Cap Rates: Your Benchmark for Real Estate Returns

Answer

Cap rate, short for capitalization rate, is a fundamental metric used by investors to evaluate the potential return of an income‑producing property. It expresses the relationship between a property's annual net operating income and its current market value, helping buyers compare deals across markets and asset types.

At its simplest, the cap rate formula is:

• Cap Rate (%) = Net Operating Income (NOI) ÷ Purchase Price × 100

For example, a building with $50,000 in NOI purchased for $1,000,000 has a cap rate of 5% (50,000 ÷ 1,000,000 × 100).

Key factors that influence cap rates:

• Market conditions: Properties in prime locations or with strong tenant demand often trade at lower cap rates (3–5%), while riskier or secondary markets may yield 8–10% or higher.
• Property type: Multifamily residential, office, retail, and industrial assets each carry distinct risk profiles and typical cap‑rate ranges.
• Interest rates and financing costs: Rising interest rates tend to push cap rates upward as buyers demand higher returns to offset borrowing expenses.
• Property condition and lease structure: Newly renovated buildings with long‑term, creditworthy tenants usually command lower cap rates than older assets with short leases.

While cap rate offers a quick snapshot of yield, it has limitations:

• It excludes debt service, tax benefits, future rent growth, and capital expenditures.
• It assumes stable income, so it may not capture value‐add or redevelopment opportunities.

As a rule of thumb, compare cap rates across similar properties and markets to gauge relative risk and pricing. For more detailed analysis, combine cap rate with other metrics like cash‑on‑cash return and internal rate of return (IRR).
Before making any investment decision, buyers are recommended to verify numbers with a licensed appraiser or real estate professional and to consult a qualified attorney or tax advisor.