A cap rate in real estate is a property’s annual net operating income divided by its purchase price or current market value, expressed as a percentage. It measures how much income a property produces relative to what it costs, without factoring in any loan. A building generating $120,000 of net operating income and priced at $2,000,000 has a cap rate of 6%. That one number lets you compare very different properties on the same terms, estimate what a building is worth, and judge a deal before financing enters the picture.
Net Operating Income: The Number That Feeds the Formula
Cap rate depends entirely on net operating income (NOI), so if NOI is wrong, the cap rate is wrong. NOI is what the property earns after the costs of running it, but before any mortgage payments or income taxes.
Start with gross potential rental income, which is what the property would collect at full occupancy with every tenant paying. Add non-rental revenue: parking, laundry, storage, late fees. Subtract a vacancy and credit loss allowance, because no building runs at 100% forever. What’s left is effective gross income.
From effective gross income, subtract operating expenses: property taxes, insurance, routine maintenance and repairs, management fees, owner-paid utilities, landscaping, and similar recurring costs.
What you leave out matters just as much. Mortgage payments and loan interest are not operating expenses. Neither are major capital improvements like a new roof or a full HVAC replacement. The IRS draws the same line for tax purposes: routine repairs that keep the property in its current condition are deductible expenses, while improvements that increase value, restore the property, or adapt it to a new use have to be capitalized and recovered over time through depreciation.1Internal Revenue Service. Publication 527 (2025), Residential Rental Property For NOI, include the maintenance and exclude the capital projects.
One caution during due diligence: verify the income and expense numbers against actual leases, bank deposits, and tax returns rather than accepting the seller’s pro forma. Sellers sometimes inflate revenue or understate costs to make a building look more profitable than it is.
The Cap Rate Formula
With NOI in hand, the math is simple:
Cap Rate = Net Operating Income ÷ Property Value
Take a 20-unit apartment building with $150,000 in annual NOI listed at $2,500,000. Divide $150,000 by $2,500,000 and you get 0.06, or 6%. For every dollar of the building’s value, the property produces six cents of net income a year before any financing costs.
Because the formula strips out debt, it works the same on a small duplex and a 300-unit complex, and it lets a cash buyer and a leveraged buyer look at the same property and agree on what its operating performance looks like.
Using Cap Rate to Estimate What a Property Is Worth
Rearrange the formula and you get a valuation tool:
Property Value = Net Operating Income ÷ Cap Rate
If an office building generates $200,000 in NOI and comparable buildings nearby are trading at a 7% cap rate, divide $200,000 by 0.07 for an estimated value of about $2,857,000. This is the income capitalization approach, one of the core methods appraisers and institutional investors use to value income-producing real estate.
Flipping the formula also shows how sensitive value is to the cap rate itself. The same $200,000 of NOI is worth $4,000,000 at a 5% cap rate and only $2,500,000 at an 8% cap rate. A $1,500,000 swing, driven entirely by what the market is willing to accept as a yield.
Typical Cap Rate Ranges by Property Type
Cap rates cluster around ranges that reflect how risky investors consider each property type, and those ranges move with market conditions. Based on industry survey data from the second half of 2025, stabilized properties were trading roughly here:
- Multifamily (apartments): 4.75% to 5.75%, with urban core at the low end and suburban slightly higher.
- Industrial (warehouses and distribution): 5.00% to 6.00%, on continued demand from logistics and e-commerce.
- Retail (neighborhood centers and NNN): 5.50% to 7.00%, with single-tenant net-leased properties on the low end and multi-tenant strip centers higher.
- Office (Class A and Class B/C): 6.75% to 8.50%, the widest range of any major property type; downtown Class A at the low end, older suburban well above 8%.
These are Class A stabilized properties in reasonably strong markets. Properties with deferred maintenance, high vacancy, or weaker locations trade at higher cap rates. The overall average across institutional-quality commercial real estate was around 5.6% in the third quarter of 2025, according to NCREIF data.
What Pushes Cap Rates Up or Down
A cap rate is more informative when you understand why it sits where it does.
Location and Demand
Dense, supply-constrained markets with strong tenant demand carry lower cap rates. Investors accept less income per dollar of value because they expect stable occupancy and long-term appreciation. In secondary or tertiary markets, buyers demand higher cap rates to compensate for vacancy risk, slower rent growth, and a thinner pool of future buyers.
Interest Rates
When interest rates rise, investors can earn more on safer assets like Treasury bonds, so they demand higher cap rates from real estate to justify the added risk. When rates fall, the opposite happens.
Cap Rate Compression and Expansion
Compression means cap rates are falling, which pushes property values up relative to income. It typically shows up in strong markets with heavy investor demand. Expansion is the reverse: rising cap rates, falling values. The period from 2022 through 2024 saw significant expansion across most property types as interest rates climbed. Which direction cap rates are moving in your target market matters as much as the current number.
Comparing Deals Using Cap Rates
The point of cap rates is comparison. A higher cap rate signals more income yield but usually means the market sees more risk. A lower cap rate means you’re paying a premium for perceived safety, stability, or growth.
If apartments in a neighborhood are trading around 5.5% and a building lists at a 4% cap rate, it’s priced aggressively; either the seller sees something the market doesn’t, or you’re being asked to overpay. A building offered at 7.5% in a 5.5% market is either a bargain or has problems the numbers don’t show. Both cases call for a closer look.
Compare like with like. A 6% cap rate on a brand-new apartment building is not the same signal as a 6% cap rate on a 40-year-old office building, because the older property likely faces near-term capital spending the cap rate doesn’t capture.
Going-In vs. Exit Cap Rate
Most cap rate talk refers to the going-in cap rate: current NOI divided by purchase price at the moment you buy. When you’re modeling a multi-year hold, you also need an exit cap rate, meaning the rate a future buyer will apply when you sell.
Exit cap rates are almost always assumed higher than going-in cap rates. Institutional underwriters commonly add 25 to 50 basis points for a five-year hold and 50 to 75 basis points for a seven- to ten-year hold. The building will be older, systems will be closer to replacement, and market conditions may have shifted. Assuming you’ll sell at the same cap rate you bought at is aggressive. Assuming you’ll sell at a lower one is almost never defensible.
The gap matters. Buy at a 5.5% cap rate, sell at a 6.5% cap rate, and value drops relative to income; total return then depends on how much NOI grew during the hold to offset that expansion.
What Cap Rate Doesn’t Tell You
Cap rate is a screening tool, not a full analysis.
It Ignores Financing
Because the metric is unlevered, it says nothing about the return on the cash you actually invest. That’s what cash-on-cash return measures: annual pre-tax cash flow (NOI minus debt service) divided by the equity you put in. Two properties with identical 6% cap rates can produce very different cash-on-cash returns. Favorable, low-rate financing might deliver 10%; expensive debt on the same property might deliver 4%.
It’s a Snapshot
Cap rate captures one year of income against value. It doesn’t account for rent growth, rising expenses, sale proceeds, or the time value of money. For total return over a hold period, investors use internal rate of return, which factors in every dollar of cash flow, when it arrives, and the eventual sale. A 5% cap rate property with strong rent growth can beat a 7% cap rate property with flat or declining rents on IRR.
It Hides Capital Expenditure Risk
NOI excludes major capital spending by design. A building with a new roof, fresh mechanicals, and renovated units has a very different risk profile than one that needs $500,000 in deferred maintenance, even if today’s NOI looks the same. Read cap rate alongside a real assessment of physical condition and a realistic capex budget for the hold period.
It Assumes Stable Operations
The formula works best on stabilized properties with predictable income. For value-add deals, lease-ups, or major repositionings, current NOI doesn’t represent what the property will look like in two or three years, so a day-one cap rate can be misleading. Investors in those deals rely more on projected stabilized NOI and total-return metrics.
None of this makes cap rate useless. It remains the most common quick-comparison tool in commercial real estate for good reason. Use it as the start of the analysis, not the end.