In commercial real estate, the capitalization rate, or cap rate, is a key metric used to estimate the potential return on an income-producing property. Expressed as a percentage, it represents the relationship between a property's net operating income (NOI) and its current market value or purchase price.
As Jonathan Squires, Managing Director at Cushman & Wakefield, puts it:
“A cap rate expresses an anticipated annual return on an investment property.”
Cap rates offer a quick, standardized way for investors to compare the profitability and risk of different real estate assets, regardless of their type or location.
What Is Considered a “Good” Cap Rate?
There’s no one-size-fits-all answer to this—what qualifies as a “good” cap rate depends on:
Your investment goals
Your risk tolerance
The property’s location
Current market conditions
In general, cap rates between 4% and 10% are considered typical across the industry. But the sweet spot varies:
Lower cap rates (4%–6%) often suggest lower risk and are common in high-demand markets.
Higher cap rates (8%–10%+) may offer better returns but usually come with higher risk.
Cap Rates by Risk Profile:
| Investment Type | Cap Rate Range | Risk/Return Profile |
|---|---|---|
| Premium Properties | 1%–4% | Lowest risk, lowest return |
| Core Assets | 4%–6% | Low risk, moderate return |
| Value-Add Properties | 6%–10% | Moderate risk and higher return |
| Opportunistic Deals | 10%+ | Highest risk, potential for highest return |
Typical Cap Rate Ranges by Property Type & Market Tier
| Property Type | Primary Markets | Secondary Markets | Tertiary Markets |
|---|---|---|---|
| Multifamily | 3.5% – 5.0% | 4.5% – 6.0% | 5.5% – 8.0% |
| Office | 4.0% – 6.0% | 5.5% – 7.5% | 7.0% – 9.5% |
| Retail | 4.5% – 6.5% | 6.0% – 8.0% | 7.5% – 10.0% |
| Industrial | 4.0% – 5.5% | 5.0% – 7.0% | 6.0% – 8.5% |
| Hotel | 5.5% – 7.5% | 7.0% – 9.0% | 8.5% – 11.0% |
Note: These are general guidelines. Actual cap rates depend on individual property features, market dynamics, and timing.
What Affects a Cap Rate?
Several factors influence whether a cap rate moves higher or lower:
Factors that Increase Cap Rates (Higher Risk / Potential Return):
Higher interest rates
Weak location or tenant quality
Short leases or instability
Economic uncertainty
Factors that Decrease Cap Rates (Lower Risk / More Stability):
Strong rental growth potential
Prime location
High-credit tenants
Long-term leases
Cap rates also fluctuate based on broader economic cycles, local demand and supply conditions, and specific property improvements or upgrades.
Why Are Cap Rates Important to Investors?
Cap rates have become a dominant decision-making metric as real estate has matured into a more institutional investment class.
“It’s usually the first question asked about a property,” says Squires.
“It’s a snapshot of perceived risk—not necessarily actual risk.”
While cap rates don’t tell the whole story, they provide a fast way to assess potential income and compare opportunities across markets and asset types.
Limitations of Cap Rates
Despite their popularity, cap rates aren’t perfect. They don’t account for:
Financing (debt service)
Capital improvements
Future income fluctuations
Market appreciation or depreciation
Cap rates can also be misleading if based on unrealistic NOI figures. Sellers sometimes underreport vacancies, omit property management fees, or use outdated tax numbers. Even in triple-net leases, owners often incur some expenses.
“It’s rare for a deal to be truly NNN,” notes Squires.
“Always verify the numbers yourself.”
How to Calculate Cap Rate
To calculate a cap rate, use this simple formula:
Cap Rate = Net Operating Income ÷ Purchase Price
Example:
Purchase Price: $2,000,000
NOI: $100,000
Cap Rate = $100,000 / $2,000,000 = 0.05 = 5%
If the property has only 90% occupancy, the adjusted NOI becomes $90,000:
Adjusted Cap Rate = $90,000 / $2,000,000 = 4.5%
This adjustment gives a more realistic view of the investment’s income potential.
Cap Rate Alternatives
While cap rate is great for quick evaluations, it’s often just the starting point. Other metrics give a more complete picture:
| Metric | Measures | Best Used For | Limitations |
|---|---|---|---|
| Cap Rate | NOI vs. property value | Initial screening | Ignores debt, capex, and future gains |
| Cash-on-Cash | Cash flow vs. investor’s cash input | Evaluating return on equity | Ignores appreciation and debt paydown |
| IRR | Overall return over time | Long-term investments | Complex; depends on future assumptions |
| Yield on Cost | NOI vs. total development cost | New builds or value-add projects | Doesn’t reflect time to stabilize |
| Terminal Cap Rate | Estimated cap rate at time of sale | Planning future exit strategies | Hard to forecast market conditions |
Going-In vs. Terminal Cap Rate
Going-In Cap Rate: NOI before purchase ÷ purchase price
Terminal Cap Rate: Projected NOI at exit ÷ expected sale price
The comparison helps investors forecast long-term profitability and determine whether to buy or build.
A Word on Internal Rate of Return (IRR)
Where cap rate gives a snapshot, IRR looks at long-term performance—factoring in both cash flow and resale value. Combining both helps balance short-term and long-term investment perspectives.
Price Per Square Foot
Another useful benchmark is price per square foot, especially for value comparisons:
“If a building is priced low per square foot, but has a low cap rate, investors might still find it appealing if rent growth is expected,” says Squires.
Final Thoughts
Cap rates are a helpful starting point—but they’re just one piece of the puzzle. Smart investors analyze:
NOI accuracy
Occupancy trends
Local market dynamics
Financing terms
Long-term growth potential
“Always do your own math,” Squires advises.
“Cap rates are only as reliable as the numbers behind them.”
When used alongside other metrics, cap rates can help guide sound, informed real estate investment decisions.
