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Capitalization rate (cap rate) is the most widely used metric in commercial real estate to evaluate an investment property's potential return. It represents the ratio of a property's net operating income (NOI) to its current market value or purchase price.
Cap rate tells you the unleveraged yield on a property — what you'd earn if you bought it outright with no mortgage. It's the quickest way to compare investment properties, regardless of size or price.
The formula is straightforward:
Cap Rate = (Annual Net Operating Income / Property Value) x 100
For example, a property worth $2,000,000 generating $160,000 in annual NOI has a cap rate of 8.0%. That means you'd earn 8% annually on your investment before financing costs.
Net Operating Income (NOI) equals gross rental income minus operating expenses (property taxes, insurance, maintenance, management fees, vacancy allowance). It does not include mortgage payments, depreciation, or capital expenditures.
There's no universal "good" cap rate — it depends on the property type, location, and risk profile. Here's a general guide for U.S. commercial properties:
| Property Type | Typical Cap Rate | Risk Level |
|---|---|---|
| Class A Multifamily (Gateway City) | 3.5% – 5.0% | Lower risk |
| Class B/C Multifamily | 5.0% – 7.0% | Moderate risk |
| Office (CBD) | 5.5% – 7.5% | Moderate risk |
| Industrial / Warehouse | 5.0% – 7.0% | Lower–moderate |
| Retail (NNN Leased) | 5.5% – 7.5% | Moderate risk |
| Self-Storage | 5.0% – 8.0% | Moderate risk |
| Value-Add / Distressed | 8.0% – 12.0%+ | Higher risk |
Lower cap rates (3–5%) typically mean lower risk, stable tenants, and prime locations — but less cash flow. Higher cap rates (8%+) suggest higher risk or value-add potential, with more cash flow but also more uncertainty.
Cap rate is just one piece of the puzzle. For a complete deal analysis, experienced investors also look at:
Cash-on-Cash Return — measures your actual cash yield after financing. Unlike cap rate, it factors in your mortgage payments and down payment amount.
Internal Rate of Return (IRR) — accounts for the time value of money across the full hold period, including appreciation, debt paydown, and eventual sale proceeds.
Debt Service Coverage Ratio (DSCR) — tells you whether the property's income covers its debt obligations. Lenders typically require 1.20x or higher.