Cap rate, short for capitalization rate, is calculated by dividing a property’s Net Operating Income (NOI) by its purchase price or current market value, expressed as a percentage. For example, a property with $80,000 in NOI purchased for $1,000,000 has an 8% cap rate. It’s a quick way to gauge a property’s return relative to its price, independent of financing.
Cap rate is useful for comparing similar properties in similar markets, but it’s not a complete picture of return on its own. It doesn’t account for financing costs, so a property’s cap rate is the same whether you buy in cash or with a mortgage, even though your actual cash-on-cash return will differ significantly based on leverage. It also doesn’t account for appreciation potential or future income growth.
Different property types and markets carry different typical cap rate ranges. Generally, lower cap rates suggest lower perceived risk and/or stronger growth expectations (common in prime locations or newer, well-leased properties), while higher cap rates suggest higher risk or a market with less competition for that asset type. A single-tenant NNN property with a strong national credit tenant will often trade at a lower cap rate than a multi-tenant property with shorter lease terms and rollover risk.
It’s important not to chase cap rate as the only metric. A property with an unusually high cap rate compared to similar properties in the area often signals hidden risk — deferred maintenance, upcoming lease expirations, or a challenging tenant mix — rather than simply being a better deal. Cap rate is a starting point for comparison, not a substitute for full due diligence.