If there's one number that runs commercial real estate, it's the cap rate. Every broker conversation, every deal analysis, every institutional transaction comes back to it. Before you can talk to a broker or read an OM without looking lost, you need to understand what cap rates are, how they work, and — just as important — what they hide.

The formula

That's it. Annual net operating income divided by the price you paid (or the price being asked).

Example. A property produces $250,000 of NOI per year and is listed for $5,000,000.

$250,000 ÷ $5,000,000 = 5.0% cap rate

Equivalently, if you know the NOI and the cap rate, you can find the value:

Example. Same $250,000 NOI, but you think a 6% cap rate is appropriate for the risk level.

$250,000 ÷ 0.06 = $4,166,667

This little reversal is one of the most important equations in commercial real estate, because it's how you sanity-check every asking price you see.

What cap rate actually measures

Cap rate is the unlevered, pre-tax, first-year yield on a commercial property. Read that phrase carefully — every word is doing work.

Unlevered: no mortgage assumed. Cap rate is what the building would yield if you paid all cash.
Pre-tax: before income taxes, depreciation, or tax benefits.
First-year: based on trailing or in-place NOI, not projected.
Yield: annual income as a percentage of price.

This matters because cap rate is NOT:

Your actual return (you'll almost certainly use leverage, which changes everything)
A projection of future performance (it's a snapshot)
An after-tax number (depreciation and write-offs come later)
A risk-adjusted measure (you need context for that)

People who treat cap rate as "my return" on a deal are going to be wrong, sometimes badly. Cap rate is the starting point, not the answer.

Higher cap rate = higher risk (or higher reward)

The core intuition is this: a higher cap rate means the buyer is paying less per dollar of income. That's either because:

The market thinks the income is risky (might not continue)
The property is in a weaker location or submarket
The tenant has weaker credit or a shorter lease
The market is inefficient and you found a deal
The property has hidden problems nobody knows about yet

Conversely, a lower cap rate means buyers are paying more per dollar of income — because they see that income as very safe or very likely to grow.

Quick mental model:

| Cap rate | What it usually signals | |---|---| | 4.0–5.0% | Trophy assets, investment-grade tenants, prime locations | | 5.0–6.5% | Solid deals in strong markets, good credit, normal terms | | 6.5–8.0% | Secondary markets, average tenants, minor hair on the deal | | 8.0–10.0% | Weak markets, short leases, problem tenants, or distress | | 10.0%+ | Something is wrong — either the risk or the underwriting |

These ranges vary by asset class. A 4% cap rate on a Walgreens is aggressive but normal; a 4% cap rate on a Class C office is ridiculous.

The two cap rates that trip up beginners

"Going-in" cap rate

The cap rate at the time of purchase, using today's NOI and the purchase price. This is what brokers quote. If someone says "it's a 6 cap," they mean the going-in cap rate.

"Stabilized" or "pro forma" cap rate

The cap rate you'd achieve after you've implemented your business plan — renovations done, rents raised, vacancies filled. This is often dramatically higher than the going-in cap rate on value-add deals.

Example. A property produces $200,000 of current NOI on a $4M asking price = 5% going-in cap. Your business plan: renovate the units and raise rents, reaching $300,000 of NOI in year 3. On the same $4M purchase, your stabilized cap is $300K/$4M = 7.5%.

Both numbers are useful. The going-in cap tells you what you're buying today. The stabilized cap tells you what you're buying if your plan works.

Brokers often confuse the two (sometimes innocently, sometimes not). Always ask which cap rate they're quoting.

The big mistake: treating cap rate as your return

The single most common mistake new CRE investors make is thinking "a 7% cap rate is a 7% return." It isn't.

Here's why:

Cap rate assumes all-cash, but you'll use leverage. Say you buy at a 7% cap with 75% LTV at 6.5% interest:

Unlevered yield (cap rate): 7.0%
Interest on debt: 6.5% of 75% = 4.875%
Levered cash yield: (7.0% − 4.875%) ÷ 25% = roughly 8.5% cash-on-cash

So leverage moved the return from 7% to 8.5%, even though the property didn't change at all. That's the positive leverage effect when cap rate is higher than interest rate.

The reverse also happens. On a 4% cap rate deal with 6.5% debt, leverage subtracts from your return — you're borrowing at 6.5% to earn 4%. That's negative leverage, and it destroys deals.

What cap rate doesn't tell you

A 6% cap rate deal can be great, average, or terrible. Here's what the cap rate number alone won't reveal:

Tenant credit. A 6 cap from an investment-grade national retailer is totally different from a 6 cap from a local mom-and-pop.
Lease term remaining. 20 years vs. 18 months is night and day.
Rent-to-market. Is rent above, at, or below market? Below-market rent is upside; above-market rent is a trap.
Deferred maintenance. Is there $400K of repairs coming in year 2?
Rent escalations. Flat rent vs. 3% annual bumps changes the hold return dramatically.
Submarket trajectory. Is the area growing or dying?

This is why cap rate is the starting point, not the answer. You use cap rate to qualify a deal for further underwriting; you don't use it to decide whether to buy.

How brokers quote cap rates

When you're talking to a broker, you'll hear phrases like:

"It's marketed as a 6 cap." — listing cap rate based on the broker's NOI, which you should verify.
"It'll trade in the high 5s." — broker's opinion of clearing price.
"The buyer got it at a 6.25." — realized cap at closing.
"We're showing a 7 pro forma." — after value-add, projected.

Brokers sometimes use optimistic NOI assumptions to make a cap rate look better than reality. Always recalculate the NOI yourself from the rent roll and the T-12, and then back into your own cap rate number. That's your cap rate. The broker's number is marketing.

Cap rate vs. other metrics

You'll learn all of these in the next lessons, but here's how cap rate relates to the other key numbers:

Cap rate — unlevered yield, first-year
Cash-on-cash return — levered yield, first-year
IRR — levered, time-weighted return over the entire hold period
Equity multiple — total cash returned ÷ cash invested

A deal might have a 5% cap rate but a 12% cash-on-cash return and an 18% IRR — those three numbers are all measuring different things, and all three can be true simultaneously. Never confuse them.

What to take away

Cap rate = NOI ÷ Purchase Price.
It's an unlevered, pre-tax, first-year yield — a snapshot, not a return.
Higher cap rate = higher risk (or higher reward) and vice versa.
Always distinguish going-in cap from stabilized / pro forma cap.
Cap rate is the starting point, not the answer. It qualifies a deal for further underwriting.
Always recalculate the NOI yourself rather than trusting a broker's number.
Leverage can make a cap rate look much better (positive leverage) or much worse (negative leverage).

Next lesson: NOI — the number that drives the cap rate, and the one where sellers most often lie.

Cap Rate — The Single Most Important Number in CRE