CRE 101

A guide to cap rate; CRE’s most versatile metric

December 24, 2021

Buying commercial real estate differs from a single-family home purchase in one important way: it generates regular revenue. A home may make you money when you sell it if it has appreciated, but CRE delivers consistent income as you collect rents, parking fees, and so on.

That’s why you need a method to compare CRE investments that consider revenue along with the purchase price.

One of the most popular options to benchmark the value of commercial properties is by their capitalization rate. Cap rate allows real estate investors to quickly assess the return and risk potential of a property, compare it to other potential investments, and place it in the context of the market as a whole.
What is cap rate?Capitalization rate is a metric that shows the amount of revenue an investment can produce in one year as a percentage of its initial cost. It’s a simple way to estimate the return on investment and inherent risk of CRE to make better investment decisions.

Cap rate is often used to compare the potential cash flow and risk from investments competing for your capital. Essentially, cap rate answers the question: “Is this the smartest place to invest my money right now?”

Cap rate can be used for any revenue-producing investment, but it’s become a de facto standard in commercial real estate, especially rental properties. You’ll see it highlighted in many CRE property listings.

Investment real estate brokerage firm Horvath & Tremblay includes cap rate in its property advertisements. (image sourced from a Horvath & Tremblay email)

CBRE even publishes a quarterly update on market cap rates for several CRE types.

One of the reasons for the cap rate’s industry-wide adoption is its simplicity. It only takes two factors to calculate: yearly income and initial cost. And both inputs are readily available.

Cap rate is also flexible. It allows you to compare potential investments regardless of their sales price, unlike the comp method often used in residential real estate. That means you can weigh the risk and return of a $1mil office building, a $500k warehouse, and a $350k hotel using cap rate.

Cap rate formula

In CRE, the cap rate calculation is the annual net operating income (NOI) divided by the current market value of a property, multiplied by 100 to get a percent.

Cap rate = (NOI / Market value) x 100

Gathering the correct data and calculating cap rates is a three-step process.

Step 1: Get the current market value of the property

Ideally, you’ll use the current fair market value in cap rate calculations. This often comes from the listing price. If the property’s not for sale, pull a recently sold comparable property as an estimate.

Occasionally, you may have to use another method to estimate asset value. A cost valuation, for example, tells you how much you’d pay to replace the land and structure. Or you can use the amount that the property most recently sold for.

These are less reliable options since they may not reflect what the property is worth today.

Step 2: Estimate property’s net operating income of the property

NOI is the total yearly gross revenue the property produces, less all operating expenses.

NOI = Gross revenue – Operating expenses

Gross revenue includes rental income, parking fees, food service, and so on. Operating expenses include regular upkeep, property taxes, building management, and insurance.

If the property has stabilized income—it’s fully leased at market rents—then the current NOI is ideal. If, however, the asset isn’t performing to full market capacity, you can use the fully realized potential NOI to calculate cap rate.

Note that cap rate assumes an all-cash purchase. Meaning it doesn’t take into account mortgage payments. That assures a common baseline of comparison since each buyer would bear a different loan cost—or no loan cost at all in cash sales.

Cap rate also does not consider depreciation. That’s because the metric bases value on the expected cash return while you own a property. Depreciation won’t affect that.

For new properties or those without recent income, use the going rental rates for similar properties. For example, if you’re reviewing the purchase of a brand new, urban office building, find the rental rate per square foot of a comparable office building nearby and apply it to the rentable square footage of your property.

Step 3: Do the math

Now, the easy part. Plug your data into the calculation.

If the property in question is listed for $400k and it nets $20k in operating income, its cap rate is 5%.

($20,000 / $400,000) x 100 = 5%

Notice that cap rate is inversely proportional to the property’s market price but directly proportional to the NOI. As the market price goes up, cap rate comes down and as NOI goes up, so does cap rate. That focus on income over property price is why cap rate is so useful for investment real estate.

Cap rate example

The best way to understand how cap rate works is to see it in action. We’ll run an example that assumes the entire property is fully rented, then show how to adjust for vacancies.

The list price of a 10-unit office building is $360,000. Each unit gets $3,000/month in rent, and the profit and loss statement shows $96,000 in yearly operational expenses.

Market price: $6,600,000
NOI: $264,000 ($360k gross revenue less $96k operating expenses)
Cap rate: 4% ($264,000 / $6,600,000 = .04 or 4%)

This scenario assumes every space is fully rented. In reality, a building with multiple tenants will have some vacancies. So, many CRE pros build in a 5% to 10% loss of rent into their cap rate calculation.

If we want to assume that our building will be at 90% capacity, we will multiply the gross revenue by 0.90.

$360,000 x 0.9 = $324,000

And our new cap rate is 3.4%.

(324,000 - $96,000) / 6,600,000 = .034 x 100 = 3.4%

Notice how big of an effect vacancies have on cap rate. So, when you see a property listing that shows a cap rate, it’s important to know if it’s realistic considering the property’s historical vacancy rate.

Cap rate calculator

A cap rate calculator will make it easy to crunch the numbers for several different scenarios.

In biproxi, for example, our Valuation Calculator auto-fills information from the listing you’re currently viewing but allows you to edit the inputs for your unique situation.

biproxi’s valuation calculator makes it easy to assess each listing and financial scenario. (screengrab from

Once you’ve plugged in your data, the calculator provides an overview of the expected risk and return for that situation.

Cap rate use cases

As an investor, you’re constantly comparing the best place to deploy your capital, assessing the risk of each option, and placing those decisions in the context of the greater market. Cap rate helps with all of that.

Compare two CRE investments

Cap rate is really helpful for comparing one potential CRE investment against another because you can place properties of different values on a level playing field.

Let’s say two properties come across your desk. The first is a $2mil warehouse with $120k in NOI. The other is a $6mil office building with $240k NOI.

At first look, $240k looks better. But the warehouse has a 6% cap rate while the office building has a lower cap rate of 4%. That means the warehouse nets more revenue per dollar tied up in the investment. From an income standpoint, you’d be better off buying the warehouse and looking for another opportunity for the rest of your capital.  

Assessing risk premium

If a high return rate was the only investment factor to consider, everyone would just buy lottery tickets. But you also have to consider the risk of losing your initial investment. The risk premium between two cap rates is one way to do that.

Risk premium explained

The risk premium is the additional rate of return you’d get from a higher-risk investment compared to a less-risky option. It not only tells you how much more money you can make from a riskier investment, but it suggests how much riskier that investment is.

For example, a treasury bond is super safe (the U.S. government is not likely to default) and yields a 2% return. By contrast, junk bonds are much less safe (could depreciate) and yield 8% in a year. The risk premium between the two is 6%.

The risk premium is driven by the fact that investors will pay less for a riskier investment, so their return as a percentage of the initial investment (the yield) is higher.

Risk premium in CRE

The same is true for commercial properties. Urban office space is considered less risky than its rural counterpart because there’s more demand for space in a big city. So, investors will pay a premium for the “safe bet” of the urban office building. The higher buy price decreases, or “compresses,” the cap rate of those assets compared to rural buildings.

When you see an urban building with a 3% cap rate and a rural property with an 8% cap rate, you can assume that the price of the rural building is lower because it’s a riskier investment. But it also has a higher return potential compared to the buy price. That’s the reward, or risk premium, for investors who are willing to take the risk.

Property class, tenant financial strength, and market volatility all tend to affect buy price and, in turn, the cap rate and risk premiums of CRE assets.

Compare current vs. new investment opportunities

If you’re holding an investment property, it would be useful to know if it makes sense to sell and redeploy capital elsewhere or keep the investment you have. Use cap rate to guide your decision.

Here’s an example. Let’s say you bought a building 10 years ago for $400k with $32k in NOI. It was an 8-cap property then.

Now the building is worth $1mil and NOI has increased by 100%. The new, lower cap rate is 6.4%. That means keeping it is a $1mil opportunity cost.

If another property comes for sale with a cap rate of 7.5%, it would be better from a return perspective to sell your current asset and redeploy that capital to the new building.

Set your ideal offer price

With a little algebraic manipulation, you can use the cap rate calculation to back into an offer price that matches the market and your own return/risk goals.

Start by choosing a market cap rate either from the CBRE report or based on your investment style (higher cap rate for greater return and risk tolerance).

Now, swap cap rate and market price in the equation. The new formula looks like this:

NOI / Cap rate = Property value

So, if you locate a property listed for $2.9mil with an NOI of $165,000 listed in a 6-cap market, you can confidently offer $2.75 million.

$165,000/0.6 = $2,750,000

The same tactic works for estimating the amount you can finance. Banks value CRE based on income, so you can estimate the value they’ll place on your property based on its ability to generate a return at market rates.

Understand real estate market trends

Cap rates are a direct indicator of current market conditions, so recent cap rate trends expose the market’s cycle stage.

When cap rates expand (increase), it indicates a drop in prices; when they compress (decrease), then the market’s heating up.

Cap rate expansion is often caused by excessive supply, rising interest rates, or something larger like a recession that’s driving prices down.

Average cap rates compressed in the mid-’00 boom, then quickly expanded in the recession of ’09. (source)

On the other hand, very low cap rates suggest the market is at its peak. If your goal is to profit from quickly rising prices, this may not be the best time to buy.

Limitations of cap rate

Cap rates are a versatile tool for quickly assessing the strengths of various investments. But there are situations—especially when something is unstable—where cap rate isn’t the best option.

Less useful for value-add properties

Value-add properties are real estate that needs some type of fix—like physical repairs or professional property management—to reach their full revenue potential. Cap rate doesn’t take additional costs into account, even though those costs can significantly affect the overall return on the investment.

Besides additional costs, value-add properties often have vacancies and lower-than-market rents (known as being unstabilized), which also skew a cap rate calculation. And since the BRRRR method of commercial real estate investing is built to take advantage of value-add opportunities, cap rate isn’t ideal for it.

One fix is to use a pro forma cap rate, which accounts for rehab costs.

Not reliable in unstable real estate markets

A wildly shifting market, like what we experienced during the pandemic, will reflect in NOIs. With properties losing tenants and prices in some markets falling, the last 12 months' unstable income may net an unrealistic future cap rate.

Besides a recession, other shifts break NOI calculations, like a change in tax or interest rates. Those factors encourage investors to either hold on to capital or deploy it faster, affecting prices.

The best solution for calculating cap rates in a volatile market is to annualize the most recent one to three months’ worth of NOI rather than using the entire year.

Doesn’t consider expiring leases

As mentioned, cap rate assumes that income is stable. If a property is about to lose a large tenant, it won’t be.

Look at two identical retail buildings. Each has the same NOI and list price and is anchored by a national pharmacy. On the surface, they look like identically situated investments for both risk and revenue.

But one of the tenants has 10 years left on a lease, and the other lease is up in eight months. Even if the second tenant stays, you may have to negotiate a new lease (changing NOI).

The best way to avoid the situation is through proper due diligence.

Cap rate vs. GRM vs. cash-on-cash return

While cap rate is one of the most used metrics in CRE, there are a couple of others that help fill in the gaps that cap rate leaves.

Gross Rent Multiplier

Gross rent multiplier is the ratio of the property’s value to the annual gross rent it produces.

Property value / Gross Annual Rent = GRM

For example, an office building listed for $2 million with an annual gross rental income of $240,000 has a GRM of 8.3.

$2,000,000 / $240,000 = 8.3

The benefit of GRM vs. cap rate is that you don’t need to know the operating costs to calculate it. That makes it valuable for “back of the napkin” valuations where the profit and loss statements aren’t available.

Cash-on-cash return

Cash-on-cash return is the net cash flow (after debt service) as a percentage of the actual cash invested in an asset.

Annual cash flow / Total cash invested = Cash-on-cash return

Say we put $500,000 in cash down on a $2mil building that had a total annual cash flow of $170,000 (that’s $240k of NOI less $70k in debt service costs). The cash-on-cash return would be:

$170,000 / $500,000 = 34%

Cash-on-cash is a better indicator of performance than cap rate, given a specific investor’s leverage in the project. That makes it useful as a second-round review of an asset after comparing it via cap rate.

What is a good cap rate?

There’s no north-star benchmark that applies to every investor and every situation. A good cap rate is one that allows real estate investors to achieve their investment goals in the context of the current market.

Fits your investment strategy

Each investor has their own comfort level with risk and rehabbing and an expected level of return. Your goal cap rate should reflect those factors.

If you have the capacity to renovate older buildings in less stable geographies, then you’ll target listings with a higher cap rate. But if you’re happy to trade higher potential returns for passive investing, then it’s low cap properties for you.

Compares favorably to similar properties

Properties within the same location, class, and type will often fall into a tight range of cap rates. So, the “best” one might just be the best in that cohort of assets.

A new, multifamily residential building located in a large urban market will attract lots of high-credit tenants at both the top and bottom of the economic cycle. Big city apartment buildings tend to have less risk, high value, and low cap rates collectively.

Conversely, a small-town hotel has less demand, especially in down markets when fewer people travel. In response, the cap rates will be higher.

Comparing cap rates between the two types of investments won’t make sense because one will almost always be higher than the other. Instead, compare cap rates between similar types of CRE to get the real feel for which opportunities are the strongest.

Stands out in the current market

Overall, cap rates tend to fall between 3% and 10%. Strong financial cycles see rates at the bottom of the range while economic downturns send cap rates way up.

A 4-cap building might get little traction today, but as the market heats up and competition increases, a 4-cap may see dozens of investors vying for the opportunity.

If you’re going to deploy capital now, you’ll need to assess cap rates in the context of the current market. Otherwise, you’ll be hard-pressed to find a suitable opportunity.

Cap rate helps you move fast

Private equity funds are sitting on a lot of dry powder, meaning fund managers have the capital to snap up any profitable commercial real estate deal that becomes available. As an individual investor, you have to assess potential investments fast—or risk missing a great opportunity.

As a tool to quickly compare investment opportunities against each other and the market as a whole, cap rate can help you create a deal pipeline faster.

Once you master the cap rate metric, you’ll judge the quality of a CRE investment in a few seconds, giving you the agility to snap up a few deals of your own.

Ember Hansen
With over a decade of marketing & business development experience, Ember brings a fresh perspective on CRE to the biproxi leadership team by turning her passion for SaaS into actionable insights for brokers and investors looking leverage technology to create a more successful business.
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