Cap Rate
A capitalization rate is a property's net operating income divided by its value or purchase price, expressed as a percentage. It is the market's shorthand for what a stream of property income is worth.
Cap Rate = Net Operating Income / Property Value
What a cap rate measures
A capitalization rate expresses the relationship between a property's annual income and its price. A property producing $364,000 of NOI that trades for $5,200,000 sold at a 7.0 percent cap rate.
Read one way it is a yield: the unlevered return a buyer earns in year one. Read the other way it is a multiple: a 5 percent cap rate is 20 times income, a 10 percent cap rate is 10 times income. Low cap rates mean buyers are paying more for each dollar of income, usually because they expect that income to grow or consider it unusually safe.
How it is calculated
Cap Rate = Net Operating Income / Property Value
Rearranged, it is also the standard way to derive value from income: Value = NOI / Cap Rate. That second form is what makes cap rates load-bearing in an underwrite, because a small change in the assumed rate moves the value conclusion a long way.
A worked example
A property with $364,000 of NOI valued at a 6.5 percent cap rate is worth $5,600,000. The same property at a 7.5 percent cap rate is worth $4,853,000. One point of cap rate moved the value by roughly $750,000, or 13 percent, with no change to the property.
What moves cap rates
- Interest rates and the cost of debt. When borrowing costs rise, buyers bid less for the same income.
- Property type and quality. Stabilized industrial and grocery-anchored retail generally trade tighter than hotels or older office.
- Market and submarket. Depth of buyer demand, population and employment trends, and the supply pipeline.
- Lease structure and term. Long-dated leases to strong credit tenants trade tighter than short-term or month-to-month income.
How lenders use cap rates
A lender is rarely the buyer, so a cap rate is a check rather than a decision. Credit teams use it to test whether an appraisal's value conclusion is consistent with actual transactions in the same submarket and property type, and to model what happens to LTV if cap rates widen between closing and maturity. That second test is the substance of most stress testing on a maturity-driven book.
Where cap rates go wrong
The most common problem is a comparison that is not a comparison. A cap rate derived from a broker's marketing NOI is not comparable to one derived from audited trailing income, because the numerators were built differently. Cap rates quoted from a listing rather than a closed sale reflect an asking price. And a single trade in a thin submarket is an anecdote rather than a market.