What cap rate means
Value = net operating income ÷ cap rate
The capitalization rate is the unlevered annual return a property produces: what you'd earn each year if you paid all cash. It lets you compare buildings of different sizes and prices on equal terms, and it is the main tool appraisers use to value income property. Flip the formula around and a cap rate turns income into a value.
Cap rates move in the opposite direction to value. If market cap rates for your property type rise from 6% to 7%, the same income is worth about 14% less. That is why commercial values fell in many markets after interest rates went up, even where rents held steady.
Getting NOI right
A cap rate is only as good as the net operating income behind it. Sellers' listing sheets often show a high NOI; buyers, appraisers and lenders all build their own lower version:
- Start with rent at current leases (or market rent if leases are above market) plus other income such as parking or laundry.
- Subtract vacancy and credit loss, usually at least 5% even for a full building.
- Subtract every operating expense: property taxes (reassessed at the purchase price if you're buying), insurance, utilities you pay, repairs, management (3–5% even if you self-manage) and replacement reserves.
- Do not subtract loan payments, depreciation, income taxes or one-off capital projects.
Worked example
A building with $300,000 of gross income, 5% vacancy and $105,000 of operating expenses has NOI of $180,000. At a price of $2,500,000 that is a 7.20% cap rate. At a 7% market cap rate, the same income supports a value of about $2,571,429; at 8%, about $2,250,000.
The expense ratio here is 36.8% of effective income. If a listing shows an expense ratio far below what similar properties run, the NOI, and the cap rate, are probably overstated.
What is a good cap rate?
There is no single good number. Cap rates reflect risk and growth: lower in strong markets and for stable property types, higher in smaller markets and for riskier assets. As a rough guide, multifamily and industrial trade at lower cap rates than retail and suburban office, and hotels and special-purpose property trade higher. Local brokers and recent appraisals are the best source for your market; the default in the calculator is an editable example, not a market figure.
A higher cap rate means more income per dollar invested, but it often comes with more vacancy risk, older buildings or weaker locations. A lower cap rate usually means a safer, more liquid asset.
Cap rate vs. your loan
Add a loan rate and the calculator compares the cap rate with the loan constant, the annual payment per dollar borrowed. At 7.25% on a 25-year amortization the constant is 8.7%. When the cap rate is above the constant, borrowing raises your cash return (positive leverage). When it's below, each borrowed dollar costs more than it earns, and lenders will cut the loan amount because the income can't cover a full-size payment. The loan amount calculator shows exactly where that limit falls.
Cap rates and refinancing
When you refinance, the appraiser values the property with a cap rate, and the new loan is sized on that value and on NOI. If you've raised rents or cut expenses since you bought, a higher NOI at the same cap rate means a higher value and possibly cash out. Run your updated NOI here, then take the value into the cash-out refinance calculator to see what a lender could release.