Definition
The capitalization rate (or cap rate) is a valuation metric that expresses a property’s unlevered income yield. It is calculated as a property’s Net Operating Income (NOI) divided by its purchase price (or current value). Cap rate is commonly used to compare pricing across properties and markets on a like-for-like basis.
How It’s Measured
Cap rate is usually quoted as an annual percentage based on forward-looking NOI (often called “in-place,†“going-in,†or “stabilized†depending on context).
Common formulas
- Cap Rate = NOI ÷ Property Value (or Purchase Price)
- Implied Value = NOI ÷ Cap Rate
Going-In vs. Stabilized Cap Rate
- Going-in cap rate: uses current/in-place NOI at acquisition (today’s income).
- Stabilized cap rate: uses projected NOI once the business plan is executed (future income).
In value-add deals, a low going-in cap rate can still be attractive if the plan credibly increases NOI and the exit assumptions are conservative.
Why It Matters
Cap rate is a quick way to translate income into value. Because value is a function of income and required return, cap rate provides a shorthand for how the market prices risk, growth, and liquidity. All else equal, a higher cap rate implies a lower value for the same NOI (and usually higher perceived risk).
What Drives Cap Rates
- Interest rates and credit conditions: higher borrowing costs can pressure cap rates upward.
- Property quality and durability: better locations, construction, and tenancy often trade at lower cap rates.
- Income stability: predictable collections and low volatility support lower cap rates.
- Growth expectations: markets with stronger rent growth prospects may trade at lower cap rates.
- Liquidity and buyer depth: more buyer demand can compress cap rates.
Investor Uses
- Pricing sanity-check: compare the implied cap rate to recent comps and market ranges.
- Back-solving value: estimate value from NOI and a market-derived cap rate.
- Exit underwriting: stress-test sale price by applying a higher “exit cap†than the entry cap.
- Market comparison: compare unlevered yields across cities, submarkets, and asset classes.
Example
A multifamily property produces $900,000 in annual NOI and is purchased for $18,000,000. The going-in cap rate is:
- Cap Rate = 900,000 ÷ 18,000,000 = 0.05 = 5.0%
If the market requires a 6.0% cap rate for similar risk, the implied value at that cap rate would be:
- Implied Value = 900,000 ÷ 0.06 = $15,000,000
Common Pitfalls
- Using the wrong NOI: mixing T-12, forward, pro forma, or stabilized NOI without labeling it.
- Ignoring capital needs: deferred maintenance can inflate NOI in the short run and mislead cap rate comparisons.
- Comparing unlike assets: cap rates differ by location, quality, age, tenancy, and deal structure.
- Confusing cap rate with return: cap rate is an unlevered snapshot, not IRR, and it excludes appreciation and financing.
- Overconfidence in “market cap ratesâ€: one or two comps can be noisy; ranges matter.