Updated · Part of the CRE investment glossary
How a cap rate works
A cap rate ties one year of income to a price. Buyers use it to compare properties of different sizes, and brokers use it to quote what a market is paying. If similar buildings trade at a 6% cap rate, a building with $600,000 of NOI is worth about $10,000,000 on that basis.
Because price and cap rate move in opposite directions, "cap rates compressed" means prices rose relative to income, and "cap rates expanded" means prices fell. The cap rate says nothing about debt, so it is the same whether the buyer pays cash or borrows 70% of the price.
One way to read a cap rate: it is roughly the unlevered return a buyer requires minus the NOI growth the buyer expects. Two buildings with the same income can trade at different cap rates because buyers expect one to grow faster or carry less risk.
Where market cap rates come from
Market cap rates are inferred from recent sales of comparable properties: the price paid divided by the NOI the buyer underwrote. Brokers and appraisers publish ranges by market and property type from those sales.
Each source defines NOI its own way — trailing or forward, with or without reserves — and few sales disclose the buyer’s actual underwriting. Treat a quoted market cap rate as a range to test against, not a fact.
The formula
Rearrange the same formula to get a value from an income figure and a market cap rate:
Cap rate = NOI ÷ value Value = NOI ÷ cap rate
- NOI: net operating income for one year — revenue minus operating expenses, before debt service and capital expenditures.
- Value: the purchase price, an appraised value or a sale price you are testing.
- Say which NOI you used: trailing (T-12), in-place annualized or projected year 1. They give different cap rates for the same price.
Worked example: what one point of cap rate is worth
The same $1,000,000 of NOI, valued at four cap rates. Each half point is a large change in price, which is why cap rate assumptions get more scrutiny than almost any other input.
| Cap rate | Calculation | Implied value |
|---|---|---|
| 5.0% | $1,000,000 ÷ 0.050 | $20,000,000 |
| 5.5% | $1,000,000 ÷ 0.055 | $18,181,818 |
| 6.0% | $1,000,000 ÷ 0.060 | $16,666,667 |
| 6.5% | $1,000,000 ÷ 0.065 | $15,384,615 |
Going-in cap rate vs exit cap rate
The going-in cap rate is year-one NOI divided by the purchase price. The exit cap rate (or terminal cap rate) is the rate you assume a buyer will pay when you sell, applied to the NOI at sale. Many underwriters set the exit cap above the going-in cap to allow for an older building and a different rate environment.
Example: you buy for $12,000,000 with $720,000 of year-one NOI, a 6.0% going-in cap rate. You project $810,000 of NOI at sale. The exit cap you pick changes the sale price by more than $1,000,000 per half point, before selling costs and loan payoff.
| Exit cap rate | Sale value | Change vs purchase price |
|---|---|---|
| 5.5% | $14,727,273 | +$2,727,273 |
| 6.0% | $13,500,000 | +$1,500,000 |
| 6.5% | $12,461,538 | +$461,538 |
Common mistakes
Cap rate errors usually come from comparing numbers that were not built the same way:
- Applying a market cap rate to pro forma NOI when the market quote was on trailing NOI.
- Comparing cap rates where one NOI includes replacement reserves and the other does not.
- Treating the cap rate as the investor return. It ignores leverage, rent growth, capital spending and the sale, which IRR and equity multiple capture.
- Assuming the exit cap equals the going-in cap with no cushion for rate or market changes.
General information, not legal, tax or investment advice. Your operating agreement, offering documents, counsel and CPA govern your deal.