The capitalization rate, or cap rate, is the most widely quoted number in commercial real estate. It’s useful, but widely misused.
The formula
Cap Rate = Net Operating Income ÷ Value (or Price)
A property with $100,000 of NOI purchased for $1,500,000 has a cap rate of about 6.7%. Rearranged, Value = NOI ÷ Cap Rate.
What NOI includes
Net Operating Income is all property revenue minus operating expenses: taxes, insurance, utilities, repairs, management and reserves. It excludes debt service, depreciation and income taxes.
What cap rates tell you
A cap rate reflects the market’s view of risk and growth. Lower cap rates (higher prices) typically mean lower perceived risk or higher expected growth; higher cap rates mean higher perceived risk or lower expected growth.
What drives cap rates
- Asset class: industrial, retail, office, self-storage, medical and multifamily trade differently.
- Tenant credit and lease term.
- Location quality.
- Building age and condition.
- Interest rates and capital markets.
- Market growth expectations.
Common mistakes
Comparing different NOI definitions
Seller-reported NOI may exclude management fees, reserves or reassessed property taxes. Normalize NOI before comparing.
Using a “pro forma” cap rate
A cap rate on projected NOI is not the same as one on actual trailing NOI. Know which you’re looking at.
Ignoring capital needs
Two properties at the same cap rate aren’t equal if one needs a new roof.
Ignoring lease rollover
A high cap rate with major leases expiring soon may not be a bargain.
Treating cap rate as return
Cap rate is an unlevered snapshot. Total return depends on financing, growth, capital costs and exit.
Texas wrinkle: property taxes
Because property taxes are significant in Texas and reassessments can follow sales, always underwrite taxes based on your purchase price. Read protesting commercial property taxes.
Frequently asked questions
Is a higher cap rate better?
A higher cap rate means a lower price relative to income, but usually reflects higher risk or lower growth.
Does cap rate include mortgage payments?
No. Cap rate is based on NOI before debt service.
How do interest rates affect cap rates?
Rising interest rates generally put upward pressure on cap rates, though the relationship isn’t one-to-one.
How we help
We normalize NOI, model scenarios and compare deals on consistent terms for Houston investors. Learn about our investor services.
Have a deal or question in mind?
Talk it through with Apurva. A 20-minute call is usually enough to know your next step.
