What Is a Capitalization Rate?
A capitalization rate expresses the unlevered annual yield a property generates relative to its price. It is calculated as net operating income divided by property value, so a building producing $800,000 of NOI that sells for $10 million trades at an 8% cap rate. Because the measure ignores financing, it lets investors compare properties on an apples-to-apples basis regardless of how any particular buyer chooses to fund the purchase.
Cap rates function like the inverse of a valuation multiple. A 5% cap rate is equivalent to paying 20 times NOI, while a 10% cap rate means paying 10 times. Lower cap rates therefore signal richer pricing, and they typically attach to safer assets, such as a fully leased apartment building in a major city, while higher cap rates compensate investors for weaker tenants or riskier locations.
How Cap Rates Are Used in Valuation
Rearranging the formula turns the cap rate into a valuation tool: value = NOI / cap rate. An appraiser who observes comparable properties trading at 6% cap rates and estimates a subject property's stabilized NOI at $1.2 million would conclude the asset is worth $20 million. This income capitalization approach is the everyday workhorse of commercial real estate pricing, sitting alongside more detailed discounted cash flow models for complex assets.
Small movements in cap rates swing values dramatically. If that same $1.2 million NOI is repriced from a 6% cap rate to 7%, value falls from $20 million to about $17.1 million, a 14% decline with no change in the property's income. This sensitivity is why real estate investors obsess over cap rate compression and expansion, which track how the market's required yield moves with interest rates and investor demand.
What Drives Cap Rates
Cap rates track the risk-free rate plus a spread for property-specific risk, minus expected income growth. When Treasury yields rise, cap rates tend to follow, pushing values down across the asset class. Asset quality matters enormously: trophy office towers and grocery-anchored retail in strong markets command low cap rates, while older buildings in shrinking metros must offer high yields to attract capital.
For students recruiting into real estate private equity, REIT investment banking coverage, or commercial lending, cap rate fluency is a screening criterion. Interviewers expect candidates to convert between cap rates and multiples instantly, explain why a buyer might accept a low going-in cap rate when NOI growth is strong, and articulate how leverage interacts with an unlevered yield to produce equity returns.
