What is a cap rate in commercial real estate?

Add a header to begin generating the table of contents

Page written by Ashlyn Brooks. Last reviewed on August 30, 2024. Next review due October 1, 2025.

Commercial real estate comes with its own set of terms, metrics, and values that carry real weight for investors. One of the most important of these metrics is the capitalization rate or ‘cap rate.’

At Swoop, we prioritize helping our clients understand the key factors influencing their financial decisions. We know that funding a commercial real estate venture is a significant commitment, and having a clear grasp of metrics like the cap rate can make all the difference in your investment strategy. That’s why we’re here to support you every step of the way, ensuring you have the knowledge and resources needed to make informed, confident decisions.

Add a header to begin generating the table of contents

What is a cap rate?

The cap rate is a financial metric used in real estate to measure the expected rate of return on an investment property. Its job? To help paint the picture by assessing the profitability and potential risk of a real estate investment. This allows investors to compare different properties more effectively.

It is expressed as a percentage and is calculated by dividing the property’s net operating income (NOI) by its current market value or acquisition cost.

Net Operating Income (NOI): This is the income generated by the property after operating expenses have been deducted, excluding any mortgage payments or taxes.
Market value: This is the current worth of the property on the open market.

The formula for calculating the cap rate is:

Cap Rate= (Property value / Net Operating Income) × 100

For example, if a property generates $100,000 in Net Operating Income (NOI) and is valued at $1,000,000, the cap rate would be 10%.

What is the cap rate for commercial real estate?

In commercial real estate, the cap rate serves as a benchmark for evaluating different properties and comparing potential returns. It is particularly useful for investors assessing the profitability of office buildings, retail spaces, industrial properties, and multi-family units.

Cap rates can vary significantly based on the type of property, its location, the current market conditions, and the perceived risk associated with the investment. For instance:

Prime locations or high-demand areas tend to have lower cap rates, reflecting lower risk and higher property values.
Emerging markets or riskier investments typically offer higher cap rates to compensate for the potential uncertainty.

How does a cap rate work?

The cap rate provides a snapshot of a property’s potential return, but as we mentioned, it’s main job is to give investors an edge in assessing the risk of different investments. A lower cap rate generally indicates a safer, more stable investment, often in a well-established market. On the other hand, a higher cap rate suggests a riskier investment, potentially in a market that is less stable or in a property that may require more management or renovation.

Investors often use cap rates to:

Compare potential investments: By looking at the cap rates of similar properties, investors can determine which offers the best return relative to its risk.
Estimate a property’s value: Investors can work backward using the cap rate to estimate what a property might be worth based on its income.

How to use cap rate?

Cap rates can be a powerful tool in your investment strategy when used correctly. Here’s how:

Determine the profitability of an investment

Calculate the cap rate to evaluate whether the potential return aligns with your investment goals. For example, if you’re considering purchasing a retail property with an NOI of $120,000 and a purchase price of $1.5 million, a cap rate of 8% might indicate that this property meets your desired return threshold.

Compare different properties

Use cap rates to compare similar properties in various markets to identify which might offer a better return. For instance, if you’re looking at two office buildings—one in a downtown area with a cap rate of 5% and another in a suburban location with a cap rate of 7%—you can weigh the potential returns against the associated risks to determine which investment might be more advantageous for you.

Assess market trends

Monitor changes in cap rates over time to gauge shifts in the market, helping you decide when it might be an optimal time to buy or sell. For example, if you notice that cap rates in a particular area have been steadily declining, this could indicate rising property values and a strong market, suggesting it might be a good time to consider selling your investment while the market is hot.

Why is cap rate important?

Cap rates are prioritized because they provide a quick and relatively easy way to assess the potential return on an investment property. When dealing in commercial real estate transactions, they tend to come with a high price tag, and investors want to mitigate risk as much as possible.

For SMEs, understanding cap rates can lead to better-informed decisions, potentially maximizing the returns on real estate investments.

How do you calculate cap rates?

Determine the Net Operating Income (NOI): Calculate the annual income the property generates after deducting all operating expenses (like maintenance, insurance, and property management fees) but before mortgage payments and taxes.
Identify the property value: Use the current market value of the property or the purchase price if it’s a recent acquisition.
Apply the formula: Divide the NOI by the property value, then multiply by 100 to get the cap rate percentage. To calculate cap rates correctly, you first need the correct data. Typically you can source this through the online listing or broker, depending on the property. If they are looking to sell and you’re a qualified buyer, they will likely provide this upon request or publish it publicly on the listing.

Here’s how you calculate the cap rate:

For example, if a property has an NOI of $80,000 and is valued at $1,000,000, the cap rate would be:

How do you calculate cap rates?

Determine the Net Operating Income (NOI): Calculate the annual income the property generates after deducting all operating expenses (like maintenance, insurance, and property management fees) but before mortgage payments and taxes.
Identify the property value: Use the current market value of the property or the purchase price if it’s a recent acquisition.
Apply the formula: Divide the NOI by the property value, then multiply by 100 to get the cap rate percentage. To calculate cap rates correctly, you first need the correct data. Typically you can source this through the online listing or broker, depending on the property. If they are looking to sell and you’re a qualified buyer, they will likely provide this upon request or publish it publicly on the listing.

Here’s how you calculate the cap rate:

For example, if a property has an NOI of $80,000 and is valued at $1,000,000, the cap rate would be:

What is a good cap rate?

Anything at or under 6% can be considered a decent cap rate, but this also sways in the balance of the current market conditions, property type, and location. Here’s what we mean:

Prime properties in top-tier markets: Think of this as a property in downtown Austin TX, where ‘Prime’ real estate gets you a high-demand office building or luxury apartment complex in the heart of the city. These properties are highly sought after due to their central location, proximity to major businesses, and vibrant lifestyle amenities. Expect cap rates between 3% and 6%, as these investments are seen as lower risk with stable, long-term income potential.
Properties in secondary or tertiary markets: This property is more of a suburban office park or a retail strip mall in neighborhoods like North Austin or the outskirts of Round Rock. These areas are growing but don’t have the same immediate demand or prestige as downtown locations. As a result, these properties might offer cap rates between 6% and 10% or higher, reflecting the increased risk due to factors like lower tenant demand or the need for significant property improvements to attract or retain tenants.

What constitutes a good cap rate is subjective and varies depending on the investor’s risk tolerance and investment strategy. Conservative investors might prefer a lower cap rate, while those seeking higher returns might be willing to accept a higher cap rate.

How reliable is a cap rate?

While cap rates are a useful tool, they are not foolproof. Like all finance metrics, several factors can affect their reliability:

Market fluctuations: Cap rates aren’t impervious to the economy and upheaval in the markets. These movements can impact NOI and property values, thereby altering the cap rate.
Property-specific risks: Issues like unexpected repairs or changes in tenant demand can affect the actual return on investment.
External economic factors: Interest rates, economic downturns, and other macroeconomic conditions can influence cap rates.

Take the real estate boom of 2022. Following the COVID-19 Pandemic, the real estate market saw a massive wave of economic upheavals that caused drastic changes in the market. Ones that were nowhere near normal rates. Here’s a comparison of 2022 versus 2023 for better visibility.

City	Property type	Cap rate 3Q 2023	Change since 2Q 2022
Los Angeles	Multifamily	4.60%	0.70%
	Industrial	4.70%	0.50%
	Office	6.70%	0.90%
	Retail	5.30%	0.10%
San Francisco	Multifamily	4.20%	0.70%
	Industrial	5.40%	0.80%
	Office	5.90%	0.90%
	Retail	5.90%	0.90%
New York	Multifamily	4.90%	0.70%
	Industrial	5.70%	0.60%
	Office	6.40%	0.80%
	Retail	5.90%	0.00%
Seattle	Multifamily	4.60%	0.70%
	Industrial	5.40%	0.60%
	Office	6.70%	0.90%
	Retail	5.80%	0.00%
Portland	Multifamily	5.10%	0.80%
	Industrial	6.60%	0.80%
	Office	7.50%	0.90%
	Retail	6.10%	0.00%
Washington, D.C.	Multifamily	5.30%	0.80%
	Industrial	6.80%	0.70%
	Office	8.40%	1.00%
	Retail	6.10%	0.00%
National Average	Multifamily	5.70%	0.80%
	Industrial	7.00%	0.80%
	Office	8.20%	0.90%
	Retail	6.80%	0.00%

How does cap rate change between class A, B, and C properties?

There’s generally a 3% to 8% fluctuation depending on the type of property you’re reviewing. Again, this metric is subjective but understanding how cap rates differ among these classes can help investors tailor their strategies based on risk tolerance and desired returns.

Class A Properties: These are top-tier properties, typically new or recently renovated, in prime locations. They offer lower cap rates, usually between 3% and 6%, due to their stability and high demand.
Class B Properties: These are older properties in good locations that may require some updates. Cap rates for Class B properties tend to be higher, ranging from 6% to 8%.
Class C Properties: These are older properties in less desirable locations or with significant maintenance needs. They come with higher cap rates, often 8% or more, reflecting the increased risk.

What factors might impact cap rate?

Cap rate can be a sensitive metric with several factors that can influence change in a positive or negative direction.

Location: Properties in prime locations generally have lower cap rates due to higher demand. But these also tend to come with a higher cost as well.
Property condition: Newer or well-maintained properties tend to have lower cap rates compared to older, less maintained ones.
Market conditions: A strong real estate market with high demand can lower cap rates, while a weaker market may increase them.
Interest rates: Rising interest rates can lead to higher cap rates as investors demand higher returns to offset the cost of borrowing.

What's the difference between cap rate and return on investment?

A cap rate is a measure of the return on a property based on its net operating income (NOI) and current market value. It does not take into account financing or tax implications. An ROI, on the other hand, is a measure of the total return on investment, factoring in elements like financing, taxes, and potential appreciation. The main differences are that the cap rate provides a snapshot of the property’s income performance relative to its value, while ROI offers a more comprehensive view of the overall profitability of the investment, including additional financial considerations.

When should I use Cap Rate and ROI?

You should use a cap rate when you want to quickly assess the potential return on a property based solely on its income relative to its market value. It’s particularly useful for comparing the income performance of similar properties or evaluating the risk and return in a specific market.

Use ROI when you need a comprehensive analysis of the investment’s overall profitability. ROI is the better metric when considering factors like financing, tax implications, and potential property appreciation. It’s ideal for understanding the full financial impact of an investment, especially when comparing different types of investments or assessing long-term gains.

Get started with Swoop

At Swoop, we’re more than just a lender—we’re your partner in navigating the complexities of business funding. We understand that SMEs often face the challenge of balancing limited resources with high potential, and we’re here to ensure you have a clear understanding of all your funding options before making any decisions.

Ready to take the next step? Visit Swoop today to explore available commercial loans, grants, and alternative financing methods we offer, and begin your commercial real estate investment journey with confidence.

Written by

Ashlyn Brooks

Ashlyn is a personal finance writer with experience in business and consumer taxes, retirement, and financial services to name a few. She has been published in USA Today, Kiplinger and Investopedia.

Swoop promise

At Swoop we want to make it easy for SMEs to understand the sometimes overwhelming world of business finance and insurance. Our goal is simple – to distill complex topics, unravel jargon, offer transparent and impartial information, and empower businesses to make smart financial decisions with confidence.

Find out more about Swoop’s editorial principles by reading our editorial policy.