How to Calculate Cap Rate for Commercial Real Estate
Cap rate (capitalization rate) is the most widely used metric in commercial real estate valuation. It's simple, powerful, and used by professionals from street-level investors to mega-fund analysts. This guide shows you exactly how to calculate it, interpret it, and use it in investment decisions.
Read time: 11 minutes | Updated April 2026
What Is Cap Rate?
Cap Rate (Capitalization Rate) is a property's first-year Net Operating Income (NOI) divided by its current purchase price or appraised value. It's expressed as a percentage and represents the unlevered cash-on-cash return, assuming no debt financing.
Cap rate is the bridge between NOI and property valuation. It tells you: "If I buy this property for $X, what percentage of that will I earn in year-one NOI?" A 5% cap rate property is less risky (lower yield) than a 7% cap rate property, all else equal.
The Cap Rate Formula
Cap Rate = NOI / Property Value
Or: Cap Rate = Year 1 NOI / Purchase Price
The formula is deceptively simple, but the power comes in applying it correctly. You need accurate NOI (revenue minus operating expenses) and the property's actual purchase price or current market value.
Step-by-Step Cap Rate Calculation
Let's work through a complete example: evaluating a 150,000 sq ft office building listed at $12M.
Step 1: Determine the Property Price
Identify the acquisition price (if buying) or current market value (if analyzing).
Purchase Price: $12,000,000
Step 2: Calculate or Verify NOI
Pull recent financial statements or build a pro forma. NOI = Revenue – Operating Expenses.
Gross Rental Income: $1,500,000
Less: Vacancy (7%): -$105,000
Effective Gross Income: $1,395,000
Operating Expenses: -$488,250
NOI: $906,750
Step 3: Divide NOI by Property Value
Apply the cap rate formula:
$906,750 ÷ $12,000,000 = 0.0756 = 7.56%
This property has a 7.56% cap rate. If you buy it for $12M, you'll earn 7.56% in year-one NOI.
Cap Rate Ranges by Property Type (2026)
Cap rates vary significantly by property type, market condition, asset quality, and risk. These are typical ranges in current market conditions:
| Property Type | Typical Cap Rate | Risk Profile | Factors |
|---|---|---|---|
| Class A Office (Downtown) | 3.5–4.5% | Low | Prime location, strong tenants, tight market |
| Class B Office (Suburban) | 5.0–6.5% | Moderate | Secondary markets, mixed tenants |
| Core Multifamily | 4.0–5.5% | Low | Strong rent growth, low vacancy, resilient |
| Value-Add Multifamily | 5.5–7.5% | Moderate-High | Below-market rents, rehab required |
| Net-Lease Retail | 4.0–5.5% | Low | NNN structure, credit tenants (e.g., CVS) |
| Class B+ Industrial (Modern) | 3.5–4.5% | Low | E-commerce driven, supply constraints |
| Class C Industrial (Older) | 6.0–8.0% | Moderate-High | Functional obsolescence, capital needed |
| Hospitality (Limited Service) | 6.0–8.0% | Moderate-High | High operating costs, market volatility |
Key insight: Lower cap rates = lower risk (but lower yield). Higher cap rates = higher yield (but higher risk). Core assets trade at 3.5–4.5% cap rates. Value-add and opportunistic deals trade at 6.0–8.0%+.
Going-In vs. Exit Cap Rates
Going-In Cap Rate
The cap rate at acquisition. You buy a property for $10M with $500k NOI = 5% going-in cap rate.
This is what you pay at day one. It's backward-looking (based on current/historical NOI) and used to evaluate the purchase price relative to income generation.
Exit Cap Rate (Terminal Cap Rate)
The assumed cap rate when you sell. If you sell in year 5 and assume a 5.5% exit cap rate, you're being conservative (higher cap rates = lower value).
Exit cap rate affects your sale price in year 5+. If market cap rates rise to 6%, your exit cap rate assumption (5.5%) was too optimistic—you'll sell for less than expected.
Example: Cap Rate Expansion/Compression
You buy a property for $10M with $500k NOI (5% going-in cap rate). After 5 years, NOI grows to $600k. You sell at 5.5% exit cap rate:
Sale Price = $600,000 / 0.055 = $10,909,091
Your property appreciated from $10M to $10.9M, partly from NOI growth but also from cap rate compression (5.0% to 5.5%).
Cap Rate Compression in a Rising Rate Environment
When the Fed raises interest rates, investors demand higher returns—cap rates rise. When rates fall, cap rates compress (fall). This is a critical dynamic to monitor.
Scenario: Cap Rate Expansion (Headwind)
You buy at 5% cap rate ($10M property with $500k NOI). Over 5 years, interest rates rise and market cap rates expand to 6%.
Year 5 NOI grows to: $600,000
At 6% exit cap rate (expanded): $600,000 / 0.06 = $10,000,000
You sell for the same price despite 20% NOI growth. Cap expansion offset your returns.
Scenario: Cap Rate Compression (Tailwind)
Same property, but interest rates fall and market cap rates compress to 4.5%.
Year 5 NOI: $600,000
At 4.5% exit cap rate (compressed): $600,000 / 0.045 = $13,333,333
You sell for 33% more than purchase price. Cap compression amplified your returns.
This is why cap rate assumptions matter in underwriting. Small changes in exit cap rate (50–100 bps) can dramatically affect exit proceeds and IRR. Always stress-test higher cap rates (e.g., +100 bps) in sensitivity analysis.
When NOT to Use Cap Rates
Development Projects (Pre-Lease)
A ground-up apartment development with no operational NOI yet can't be valued on cap rate. Use DCF or comparable development sales.
Value-Add / Repositioning Deals
Stabilized NOI may not exist yet. The property is being renovated and rents are being pushed. Use DCF with projected stabilized NOI instead.
Distressed/Highly Volatile Assets
Cap rate assumes current NOI is sustainable. In distressed deals (e.g., office with 40% vacancy), current cap rate is misleading. Forecast recovery first, then cap the stabilized NOI.
Single-Tenant Triple-Net Leases (Credit Matters)
A property leased to a strong tenant (e.g., Walmart on NNN) at 3% cap rate may be safer than a multifamily at 5% cap rate. Cap rate alone doesn't capture credit risk.
Value-Add Where Year-1 NOI Doesn't Represent Stabilization
If you buy a property mid-renovation, year-1 NOI will be artificially low. Use stabilized NOI (typically year 2–3) for cap rate valuation.
Rule of thumb: Cap rate works best for stabilized, income-producing properties with predictable NOI. For anything else, build a DCF model.
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Frequently Asked Questions
Is a higher cap rate better? ▼
Not necessarily. Higher cap rate = higher yield but also higher risk. A 7% cap rate property is riskier than a 4% cap rate property. The "best" cap rate depends on your risk appetite and return requirements. Conservative investors prefer lower cap rates (lower risk). Opportunistic investors target higher cap rates (higher returns, higher risk).
How is cap rate different from IRR? ▼
Cap rate is simple: Year 1 NOI / Purchase Price. It's a static snapshot at acquisition. IRR is the annualized return over your entire hold period, accounting for NOI growth, leverage, and sale proceeds. IRR is more comprehensive but more complex to calculate. Many investors use cap rate for quick screening and DCF/IRR for final investment decisions.
Does cap rate include debt service? ▼
No. Cap rate is unlevered—it doesn't include debt service. It measures the property's operational performance independent of financing. If you buy with different leverage (60% LTV vs 80% LTV), your equity return (cash-on-cash) changes, but the cap rate remains the same.
Can you increase cap rate after purchase? ▼
No, you can't change your going-in cap rate. But you can compress the exit cap rate through improvements. If you buy at 6% and increase NOI by 20%, the property's value rises even if market cap rates stay flat. This is the value-add strategy: buy at higher cap rate, force NOI growth, exit at lower cap rate (relative to NOI).
What cap rate should I use for underwriting? ▼
Use market-based cap rates from recent comparable sales in the same submarket. If Class A office in Austin is trading at 4% and you're underwriting a Class B property, assume 4.5–5.0% (higher due to risk). For exit cap rate, be conservative: assume 25–50 bps higher than going-in (rates may rise). Always stress-test exit cap rates in sensitivity analysis.
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