A cap rate is the shortest sentence in commercial real estate: one year of net operating income divided by price. Brokers quote it, lenders test it and buyers argue about it, often without agreeing on what went into it.
The division is easy. The inputs are where values go wrong, so this article spends most of its time there.
The one-line definition
The capitalization rate, or cap rate, is net operating income divided by value:
Cap rate = net operating income ÷ value
Turn it around and it prices a building:
Value = net operating income ÷ cap rate
Say a building earns $96,000 a year after operating expenses. At an 8.0% cap rate it is worth $1,200,000. At 7.0% it is worth about $1,371,000. Same income, two prices, about $171,000 apart.
That is the whole formula. Everything else is about getting the two inputs right.
What counts as net operating income
Net operating income, or NOI, is what the property earns before the mortgage. Start with rent. Subtract an allowance for vacancy and credit loss. Add other income such as parking or expense reimbursements. Then subtract the costs of running the building.
NOI leaves out:
- Mortgage payments, also called debt service
- Depreciation and income taxes
- Large capital projects, such as a roof replacement or a new parking lot
Many analysts deduct a reserve for replacements, a yearly set-aside for those capital items. Some do not. Neither is wrong, but the rule has to be the same for your building and for the sales the cap rate came from.
A worked example
The numbers below are illustrative. Say an owner has a 12,000 square foot two-story office building in Laramie on gross leases, so the owner pays the operating costs.
| Line | Annual amount |
|---|---|
| Rent: 12,000 sq ft at $18.00 | $216,000 |
| Less vacancy and credit loss, 7% | ($15,120) |
| Effective gross income | $200,880 |
| Property tax | ($14,400) |
| Insurance | ($6,200) |
| Utilities | ($18,600) |
| Repairs and maintenance | ($12,500) |
| Janitorial | ($9,800) |
| Management, 5% of income | ($10,044) |
| Reserve for replacements | ($3,600) |
| Net operating income | $125,736 |
Look at the management line. An owner who manages the building personally may leave it out. A buyer will not, because a buyer expects to pay someone to do that work.
The same goes for vacancy. A building that is full today still gets an allowance, because it will not be full every year of a buyer’s ownership.
A half point is real money
Now apply a range of cap rates around the evidence. Say local sales point to 8.5%.
| Cap rate | Value | Change from 8.5% |
|---|---|---|
| 7.5% | $1,676,480 | $197,233 more |
| 8.0% | $1,571,700 | $92,453 more |
| 8.5% | $1,479,247 | Base case |
| 9.0% | $1,397,067 | $82,180 less |
On this building, each half point moves the value by $80,000 to $100,000. That is why a cap rate needs a written source, and why a sound valuation shows a sensitivity table like this one instead of a single figure.
The table also shows why the effect grows as the rate falls. The same half point matters more at 7.5% than at 9.0%, because the income is being divided by a smaller number.
Where the rate comes from
A cap rate is observed, not chosen. The best evidence is recent sales of similar buildings in the same market, where both the price and the income at the time of sale are known:
Sale cap rate = NOI at sale ÷ sale price
Those rates are then adjusted for how each sale differs from your building:
- Tenant strength: a national tenant on a long lease reads differently from a new local business.
- Lease term remaining: five years of signed income is worth more than one.
- Age and condition: a new roof protects income; an old one is a bill on the way.
- Location and size: a small Wyoming town is not priced off a Denver suburb.
- Date of sale: rates move with interest rates and lender appetite.
Lending terms matter too. When mortgage rates rise, buyers need more income per dollar of price to make a loan work, which tends to push cap rates up. The link is loose, not mechanical, so it supports the sales evidence rather than replacing it.
Where sales are scarce, as they are in much of Wyoming, the analysis leans on fewer sales, sales from farther away and more reasoning, all written down. Our article on valuing property when sales are scarce covers that case.
What a cap rate is not
It is not your return. A cap rate ignores financing, rent growth, capital spending and the eventual sale. Two buildings bought at 8.0% can turn out very differently over ten years.
It is not an interest rate, though the two get compared. A low cap rate means buyers are paying more for each dollar of current income, usually because they see lower risk or expect the income to grow.
It is not one number for the life of the building. The going-in rate, at purchase, and the exit rate, at a future sale, are separate assumptions. An exit rate below the going-in rate deserves a question.
Five mistakes that move a value
- Pro forma income at a market rate. Projected rents capitalized at a rate taken from buildings with signed rents. This pairs the best case with the going rate.
- Missing expenses. No management fee, no vacancy allowance, no reserve. Each one inflates NOI and the value with it.
- Mixed conventions. Reserves deducted in the comparable sales but not in the subject building, or the other way round.
- Ignoring lease roll. A single tenant with one year left is not the same income as a single tenant with ten.
- Borrowed rates. A rate from a national survey or a bigger metro, applied to a town with a different set of buyers.
Mistakes one and two often travel together, because both make the income look larger than a buyer will see it.
Checking a listing’s cap rate
A listing that says “7.5% cap” is making a claim about two numbers: the asking price and the NOI. Check the NOI before you accept the rate.
Say a listing asks $1,500,000 for a building with stated NOI of $112,500:
$112,500 ÷ $1,500,000 = 7.5%
Now read the expense page. There is no management fee and no reserve. Add management at 4% of $130,000 in effective gross income ($5,200) and a $2,400 reserve, and NOI falls to $104,900:
$104,900 ÷ $1,500,000 = 6.99%
At the asking price, a buyer is paying a 7.0% cap rate, not 7.5%. If 7.5% is the right rate for this building, the price it supports is lower:
$104,900 ÷ 0.075 = $1,398,667
That is about $101,000 below the asking price, from two lines on the expense page. Nothing in the listing was false. It simply used a different set of expenses than a buyer would.
Check your own number
Before you rely on a cap rate from anyone, run through this list:
- Build NOI from the trailing twelve months of actual income and expenses, not the listing
- Add a vacancy allowance, even if the building is full
- Include management at a market fee, even if you manage it yourself
- Decide whether reserves are in or out, and apply the same rule to the comparables
- Ask for the sales behind the rate, with dates, prices and income
- Run the value at half a point either side
The cap rate calculator does the arithmetic and shows the sensitivity in seconds. It cannot choose the inputs for you; that is where the work is.
Cap rates inside a full valuation
The cap rate is one tool inside the income approach, and the income approach is one of three ways to price a building. The others look at what similar buildings sold for and what it would cost to build again. The article on the three approaches to value shows how they are weighed together.
When inputs need a second reader
A valuation advisory report builds NOI from the leases and the trailing twelve months, argues the cap rate from local sales and includes a sensitivity table, in 10 to 15 business days from $3,500 per property (indicative). For a narrower question, our property valuation service also offers a five-day snapshot. Bring the number you have to a free 30-minute scoping call, which ends in a fixed-fee quote in writing.
