If you’re planning to buy commercial real estate, understanding how to calculate cap rate is critical to determining if a property will be a good investment. Learning about this important metric will help you decide if a particular investment makes sense financially, so you can choose the right properties for your portfolio.
What Is a Cap Rate?
In real estate, cap rate is short for “capitalization rate.” Cap rate is a quick calculation that tells you how much income a commercial property is expected to generate relative to its purchase price without accounting for financing costs. In simple terms, cap rate tells you what percentage of the purchase price you can expect to earn back each year in rental income.
Cap Rate Vs Return on Investment (ROI)
Cap rate and return on investment (ROI) are related but are used for different purposes. Cap rate measures a property’s income relative to its value without factoring in how you finance the purchase. ROI, in contrast, accounts for your actual out-of-pocket investment, including your down payment and financing costs.
In practice, cap rate is most useful for comparing properties and assessing their market value relative to comparable assets. ROI, on the other hand, tells you how a deal on a specific property would work out for you, given your down payment and loan terms.
Cap Rate Vs Discount Rate
While the cap rate tells you how much income a property is generating right now relative to its value, the discount rate takes the time value of money into account. The time value of money reflects the idea that a dollar you earn today is less valuable than a dollar you earn tomorrow.
Discount rate is used in a broader financial analysis called Discounted Cash Flow (DCF), which incorporates projected rental income, the estimated sale price for the property, and the present (discounted) value of money you’ll earn from the investment property and its eventual sale.
The key difference between these two calculations is that the cap rate tells you whether the property looks like a good deal today, while a DCF (using the discount rate) indicates whether it will be a good investment over time, given your projections about rental growth, increases in property values, etc.
How Do You Calculate Cap Rate?
The formula is straightforward, and you can use a cap rate calculator if you’re comparing multiple properties.
First, calculate the net operating income (NOI):
NOI = Annual rental income – operating expenses (property taxes, insurance, maintenance, management fees).
Then divide the NOI by the property value to get the cap rate:
Cap Rate = Net Operating Income (NOI) ÷ Property Value
For example, if an office building brings in $150,000 in annual rent and has operating expenses of $30,000 a year, the NOI for the building is $120,000. If it’s priced at $2,000,000, the cap rate for this real estate asset is $120,000 ÷ $2,000,000, or 6%.
What’s a Good Cap Rate in 2026?
A good cap rate for a commercial property generally falls between 5% and 10%, depending on the sector, asset quality, and your investment goals.
By sector and asset quality:
- Multifamily buildings average around 5% for Class A buildings and 7% for Class B.
- Industrial buildings fall between 6% and 7.5%.
- Office buildings are around 8.5% for Class A and B structures and above 9% for Class C.
By investment goal:
- Investors looking for stability and a longer timeline should choose premium, low-risk assets in high-demand markets. A good cap rate for these goals is between 4% and 5.5%.
- Investors who want higher income and are willing to accept more risk should look for properties with cap rates between 7% and 9%.
Many beginning investors stay on the conservative end, choosing properties with lower cap rates while they gain knowledge and experience; consulting with a real estate investment advisor or commercial real estate agent is a good way to evaluate the right cap rate range for you.
Why Do Cap Rates Change?
Cap rates change for a variety of reasons, the two main ones being interest rates and investor demand for properties.
Interest Rates
When borrowing costs rise, cap rates rise as well. Although cap rate calculations don’t include financing costs, most investors borrow when they buy property, so they need to take interest rates into account. Here’s how the relationship between interest rates and cap rates works:
- When interest rates rise, the cost of borrowing goes up.
- To maintain the profitability of a deal, investors start offering lower prices for properties, which drives property prices down across the board.
- Since prices are lower but NOI is the same, cap rates rise across the market.
The reverse is also true: when borrowing costs go down, cap rates also decrease.
Expectations About Rent Growth
If rents are expected to rise for a particular property or property class, cap rates tend to decrease. When investors believe the income for a property will increase, they are willing to pay more for it, which decreases the cap rate.
Property Quality and Tenant Creditworthiness
A well-maintained building with long-term leases and creditworthy tenants will have a lower cap rate than an older property with short-term leases and an unpredictable vacancy rate.
Location and Market Conditions
A prime urban market will almost always have lower cap rates than less desirable areas.
Economic Conditions
Strong economic conditions, such as high growth and low unemployment, tend to push cap rates down. During economic downturns, cap rates tend to increase.
What Are Cap Rates in Commercial Real Estate?
In commercial real estate investing, cap rates give you a quick way to compare properties. However, it’s important to recognize that additional work is required to determine if a particular property is the right investment for you.
Once you find a property with the cap rate you’re looking for, it’s time to dive into the particulars. Key items to verify are:
- Income: What are the actual rents tenants are paying currently?
- Leases: How long are the outstanding leases, and are they likely to be renewed?
- Vacancy rates: What are the historical vacancy rates for the building, and how quickly are vacancies typically filled?
- Tenant quality: Who are the current tenants, and how financially stable are they?
- Expenses: What are the actual expenses for the building? Are there any particularly low expenses that might indicate maintenance that’s been put off?
- Upcoming capital expenditures: Are there any major repairs needed?
- Building condition: What is the overall age and condition of the building? Are there any environmental issues, such as asbestos, mold, or soil contamination, that will need to be remediated?
- Market conditions: What are comparable properties selling for in this market? Is the area growing, stable, or declining?
- Legal and regulatory issues: Are there any outstanding liens or legal disputes related to the property? Are there any zoning restrictions affecting how you can use the property?
- Existing contracts: What service agreements, leases, and management contracts are in place?
- Financing: Does the deal still hold up with the interest rate you can actually get right now?
Although cap rates are a good starting point, digging deeper is what determines whether the property is a good investment. Working with an experienced commercial real estate agent can help you interpret cap rate meaning in the context of local market conditions and your investment goals.
Frequently Asked Questions About Cap Rates
What Is a Cap Rate?
A cap rate (capitalization rate) is a figure used to assess the income potential of a commercial real estate investment. It’s used to compare properties with each other, independent of financing costs.
How Do You Calculate Cap Rate?
The formula is: Cap Rate = Net Operating Income (NOI) ÷ Property Value. NOI is your annual rental income minus operating expenses (not including mortgage payments). For example, a property that’s worth $1,000,000 and generates $70,000 in NOI has a cap rate of 7%.
What’s a Good Cap Rate in 2026?
What constitutes a good cap rate depends on the property type and market. Generally, cap rates or 5% to 7% are considered reasonable, although Class A multifamily buildings in major markets can trade closer to 4.5% to 5%, while office properties in some markets have cap rates of 8% to 9%. A good cap rate for an individual investor is one that’s consistent with their risk tolerance and investment timelines.
Why Do Cap Rates Change?
Cap rates fluctuate due to interest rate changes, investor demand, local market conditions, and property-specific factors like tenant quality and rent growth potential. When interest rates rise, cap rates tend to rise with them; when rates fall, or investor demand increases, cap rates typically decrease.
What’s the Difference Between Cap Rate and Discount Rate?
A cap rate is a property’s current income relative to its value. A discount rate is used in Discounted Cash Flow (DCF) analysis and accounts for the time value of money and projected future performance over a multi-year period. Discount rates are generally higher than cap rates and are used for more detailed and complex investment analyses.
