Cap Rate Guide for Commercial Real Estate

What Is a Cap Rate in Commercial Real Estate?

A capitalization rate (cap rate) is the most widely used metric for evaluating commercial real estate investments. It measures the relationship between a property's net operating income (NOI) and its current market value, expressed as a percentage. Investors, lenders, and appraisers rely on cap rates to quickly assess property returns, compare investment opportunities, and determine fair market pricing.

The cap rate formula is straightforward: Cap Rate = Net Operating Income / Property Value x 100. For example, a property generating $120,000 in annual NOI with a market value of $1,500,000 has a cap rate of 8.0%. This tells you the property produces an 8% annual return on its value before accounting for financing costs.

Understanding cap rates is essential whether you are acquiring your first investment property or managing a large commercial portfolio. The metric provides a standardized way to evaluate deals across property types, markets, and price points. For a deeper look at calculating NOI, the numerator of the cap rate equation, see our NOI calculation guide.

Cap rates do not account for mortgage payments, so they reflect the unlevered return on a property. This makes them useful for comparing properties regardless of how they are financed. If you plan to use debt, tools like our DSCR calculator and commercial mortgage calculator help you model the impact of financing on actual cash flow.

How Do You Calculate Cap Rate Step by Step?

Calculating a cap rate requires two inputs: net operating income and property value. Getting these numbers right is critical because small errors in either figure can dramatically shift the result.

Step 1: Calculate Net Operating Income (NOI). Start with gross potential income from all sources, including rent, parking, laundry, and other tenant charges. Subtract vacancy and credit loss (typically 5 to 10% of gross income). Then subtract all operating expenses: property taxes, insurance, maintenance, management fees, utilities, and reserves. The result is your NOI. Do not include mortgage payments, depreciation, or capital expenditures in this calculation.

Step 2: Determine Property Value. For acquisitions, use the purchase price. For existing holdings, use the current appraised value or comparable sales data. For properties not yet on the market, use comparable cap rates from similar recent sales to back into a value estimate.

Step 3: Divide NOI by Property Value. Divide NOI by the property value and multiply by 100 to express the result as a percentage. A $200,000 NOI on a $2,500,000 property equals an 8.0% cap rate.

Step 4: Verify Your Inputs. Double check that your NOI uses stabilized, annualized figures rather than trailing income from an unusual period. Ensure the property value reflects current market conditions. Errors in either input produce misleading cap rates.

For a detailed walkthrough of building accurate NOI projections, read our NOI calculation guide. You can also explore other return metrics in our cash on cash return guide.

What Are Average Cap Rates by Property Type?

Cap rates vary significantly across property types because each asset class carries a different risk profile, tenant stability level, and growth outlook. Understanding these differences helps investors benchmark deals against market norms.

Multifamily properties trade at the lowest cap rates, typically 4.5% to 6.5% in 2026. Strong demand for rental housing, long track records of stable occupancy, and favorable financing options compress multifamily cap rates. Class A apartments in top metros may trade below 4.5%, while Class C properties in secondary markets reach 7.0% or higher.

Industrial and logistics assets command cap rates of 5.0% to 7.0%, reflecting continued demand driven by e-commerce growth and supply chain nearshoring. Warehouse and distribution facilities with long-term tenants in strong logistics corridors trade at the lower end of this range.

Retail properties range from 5.5% to 8.5%, with significant variation based on tenant quality and lease structure. Single-tenant net lease properties with investment-grade tenants trade at 5.5% to 6.5%, while multi-tenant strip centers and older retail carry cap rates of 7.0% to 8.5%.

Office buildings currently sit at 6.5% to 9.5%, reflecting ongoing uncertainty about remote work trends and tenant demand. Class A office in gateway cities trades at lower cap rates, while suburban and older Class B/C office commands higher returns to compensate for elevated risk.

Self-storage facilities typically trade at 5.5% to 7.5%. Strong operator demand and the recession-resistant nature of the asset class support relatively compressed cap rates for well-located, stabilized facilities.

These ranges shift based on local market conditions, property condition, lease terms, and tenant credit quality. Investors evaluating acquisition loan opportunities should compare their target property's cap rate against these benchmarks. Need help analyzing a deal? Request a free consultation from our commercial lending team.

How Do Cap Rates Vary by Market?

Geographic location is one of the most significant factors influencing cap rates. Primary, secondary, and tertiary markets each carry distinct risk profiles that drive cap rate differences.

Primary markets like New York, Los Angeles, San Francisco, and Chicago offer the lowest cap rates, typically 4.0% to 6.0% across property types. These markets provide deep liquidity, diverse tenant demand, and transparent pricing. Investors accept lower returns because the perceived risk of vacancy and value decline is reduced.

Secondary markets such as Nashville, Austin, Charlotte, Tampa, and Denver feature cap rates of 5.5% to 7.5%. These markets combine strong growth trajectories with moderately less liquidity than gateway cities. Many investors target secondary markets for their favorable balance of yield and risk.

Tertiary markets in smaller cities and rural areas command cap rates of 7.0% to 10.0% or higher. Limited buyer pools and thinner tenant demand increase perceived risk. However, these markets can offer compelling returns for investors with local expertise.

Cap rate spreads between primary and tertiary markets typically range from 200 to 400 basis points (2.0% to 4.0%). During market downturns, this spread tends to widen as capital retreats to safer primary markets. During expansionary periods, the spread compresses as yield-seeking investors push into secondary and tertiary markets.

Investors using bridge loans to acquire and stabilize properties in secondary markets can often achieve meaningful yield premiums over primary market investments while still accessing institutional-quality assets.

What Causes Cap Rate Compression and Expansion?

Cap rate compression occurs when cap rates decrease, meaning property values rise faster than income growth. Cap rate expansion is the opposite, where cap rates increase and property values decline relative to income. Understanding these trends is essential for timing investment decisions.

Interest Rates and Monetary Policy. Interest rates are the single largest driver of cap rate movement. When the Federal Reserve lowers rates, borrowing costs decline, more capital enters real estate, and increased competition for properties pushes cap rates down. Conversely, rising rates increase financing costs, reduce buyer pools, and push cap rates higher. The 2022 to 2024 rate hiking cycle expanded cap rates by 100 to 200 basis points across most property types.

Capital Flows and Investor Demand. Strong institutional demand for commercial real estate compresses cap rates. When pension funds, insurance companies, and foreign investors allocate heavily to real estate, competition drives prices up and cap rates down. Reduced investor appetite, whether from economic uncertainty or competing returns in bonds and equities, causes expansion.

Economic Growth and Tenant Demand. Job growth, population migration, and business expansion increase tenant demand, supporting rental income growth and attracting investment capital. Markets experiencing strong economic momentum tend to see cap rate compression. Economic contraction weakens tenant demand and pushes cap rates higher.

Supply and Construction Activity. Oversupply in a market or property type can depress rents and increase vacancy, driving cap rates higher. Constrained new supply, conversely, supports landlord pricing power and attracts capital, compressing cap rates.

Risk Perception and Market Sentiment. During periods of uncertainty, investors demand higher returns (higher cap rates) to compensate for perceived risk. During stable, optimistic markets, investors accept lower returns (lower cap rates) for the same assets.

From 2020 to 2022, aggressive monetary easing compressed cap rates to historic lows across most property types. The subsequent rate increases through 2024 reversed much of that compression. As of early 2026, cap rates have stabilized in most sectors, with selective compression returning in multifamily and industrial assets as rate cuts take hold.

How Do You Use Cap Rates for Property Valuation?

The income capitalization approach is one of three primary methods for determining commercial property value, and it relies directly on cap rates. This method is particularly useful for income-producing properties where comparable sales data may be limited.

Direct Capitalization Method. The most common approach divides a property's stabilized NOI by the market cap rate for comparable properties: Property Value = NOI / Cap Rate. If a retail property generates $175,000 in NOI and comparable properties trade at 7.0% cap rates, the estimated value is $175,000 / 0.07 = $2,500,000. This method works best for stabilized properties with predictable income streams.

Finding the Right Cap Rate. Selecting the appropriate cap rate for valuation requires analyzing recent comparable sales. Look for properties with similar type, location, age, condition, tenant quality, and lease structure. Appraisers typically identify 3 to 5 comparable sales and extract their cap rates to establish a range. The subject property's cap rate is then selected based on where it falls within that quality spectrum.

Adjustments and Considerations. Raw cap rates from comparable sales often need adjustment. A property with below-market rents should be valued using a pro forma cap rate reflecting market rents. A property with near-term lease rollovers or deferred maintenance warrants a higher cap rate than a fully stabilized comparable.

Limitations of Cap Rate Valuation. The direct capitalization method assumes stable, ongoing income, making it less reliable for properties undergoing lease-up, renovation, or repositioning. For value-add properties, discounted cash flow (DCF) analysis provides a more comprehensive valuation framework.

For additional valuation approaches, review our property valuation methods guide. When you are ready to model financing on a property, try our commercial mortgage calculator. Our team can also provide lender-matched financing quotes for your specific deal. Get a free quote today.

What Is the Relationship Between Cap Rate and Risk?

Cap rates function as a risk premium indicator in commercial real estate. Higher cap rates signal higher perceived risk, while lower cap rates indicate lower risk. Understanding this relationship helps investors make informed allocation decisions.

Why Higher Cap Rates Mean Higher Risk. A 9.0% cap rate on a suburban office building means investors demand a 9.0% unlevered return to compensate for the risks of that asset class, location, and tenant profile. Those risks might include remote work trends reducing office demand, potential vacancy during lease rollovers, and limited buyer interest at resale. Compare this with a 4.5% cap rate on a Class A multifamily property in a top metro, where strong housing demand, minimal vacancy risk, and deep liquidity justify accepting a lower return.

The Cap Rate Spread Over Treasuries. Investors often measure cap rates relative to the 10-year Treasury yield to assess whether real estate offers adequate compensation. Historically, cap rate spreads over the 10-year Treasury average 200 to 300 basis points. When spreads compress below 150 basis points, real estate may be overpriced relative to risk-free alternatives. When spreads exceed 350 basis points, real estate typically offers compelling relative value.

Risk Factors That Influence Individual Property Cap Rates:

• Tenant credit quality and lease duration
• Property age, condition, and capital expenditure needs
• Market size, liquidity, and economic diversity
• Occupancy rate and historical vacancy trends
• Remaining lease term and rollover schedule
• Environmental or regulatory risks
• Management intensity and operational complexity

Matching Cap Rate to Investment Strategy. Core investors targeting stability and capital preservation focus on properties with 4.0% to 6.0% cap rates. Value-add investors seeking higher returns through operational improvements target 6.0% to 8.0% cap rates. Opportunistic investors willing to take on development, repositioning, or distressed assets target 8.0% or higher.

Investors pursuing higher-cap-rate properties often benefit from bridge loan financing to fund acquisition and stabilization before refinancing into a permanent loan at a lower rate.

What Are the Limitations of Cap Rate Analysis?

While cap rates are indispensable for commercial real estate analysis, relying on them exclusively leads to incomplete conclusions. Sophisticated investors use cap rates as one tool within a broader analytical framework.

Cap rates ignore financing structure. Two identical properties purchased at the same cap rate can produce dramatically different cash-on-cash returns depending on loan terms, leverage, and interest rates. A property purchased at a 7.0% cap rate with 65% leverage at 6.5% interest produces a very different equity return than the same property purchased with 80% leverage at 8.0% interest. Always layer in financing analysis using tools like our DSCR calculator.

Cap rates are a single-period snapshot. The cap rate formula uses one year of income, ignoring future rent growth, lease expirations, planned capital expenditures, and changing market conditions. A property with flat rents and expiring leases might show the same cap rate as one with embedded rent escalations and long-term leases, despite offering very different forward-looking returns.

Cap rates do not capture appreciation potential. Value-add properties with below-market rents or operational inefficiencies may show high cap rates based on current income but offer significant upside through management improvements. A low cap rate on a fully optimized property may leave little room for additional value creation.

Cap rates vary based on how NOI is calculated. Differences in expense assumptions, vacancy projections, management fee treatment, and reserve allocations can produce materially different NOI figures, and therefore different cap rates, for the same property. Always verify the NOI methodology behind any quoted cap rate.

Cap rates do not account for capital expenditure timing. A property requiring $500,000 in roof replacement next year presents a very different investment proposition than one with a new roof, even if both show identical cap rates today.

Complementary Metrics to Use Alongside Cap Rates:

• Cash-on-cash return (accounts for leverage)
• Internal rate of return, or IRR (captures multi-year performance)
• Equity multiple (total return on invested capital)
• Debt yield (lender's perspective on income coverage)
• Price per unit or price per square foot (physical benchmarks)

For a comprehensive investment analysis, combine cap rate evaluation with cash flow modeling. Learn how in our cash on cash return guide.

Frequently Asked Questions About Cap Rates?

What is a good cap rate for commercial real estate? A "good" cap rate depends on your investment strategy, risk tolerance, and target market. Core investors in primary markets typically accept 4.0% to 5.5%. Value-add investors target 6.0% to 8.0%. Opportunistic investors pursue 8.0% or higher. The right cap rate balances your return requirements against the risk profile of the specific asset.

How do cap rates affect property values? Cap rates and property values move inversely. When cap rates decrease (compress), property values increase for the same level of income. When cap rates increase (expand), property values decline. A 1.0% change in cap rate can shift property values by 15% to 25%, making cap rate trends a critical factor in investment timing.

What is the difference between cap rate and cash-on-cash return? Cap rate measures unlevered return (NOI divided by property value) without considering financing. Cash-on-cash return measures levered return (pre-tax cash flow divided by total equity invested) and accounts for mortgage payments, closing costs, and actual capital invested. A property can have a 6.0% cap rate but produce a 10% cash-on-cash return with favorable leverage.

Do cap rates include mortgage payments? No. Cap rates are calculated using NOI before debt service. This is intentional because it allows investors to compare properties on an equal basis regardless of financing structure. To analyze returns after mortgage payments, use cash-on-cash return or total return metrics.

Why are cap rates lower in major cities? Major cities offer deeper liquidity, larger tenant pools, stronger economic fundamentals, and greater transparency. These factors reduce investment risk, so investors accept lower returns. Primary market properties also attract more competing buyers, including institutional investors and foreign capital, which drives prices up and cap rates down.

How do interest rates affect cap rates? Interest rates influence cap rates through borrowing costs and competing investment returns. Rising interest rates tend to push cap rates higher because increased financing costs reduce what buyers can pay for properties. Falling rates have the opposite effect, compressing cap rates as cheaper debt enables higher purchase prices. The correlation is not perfect, but interest rate direction is the strongest predictor of cap rate movement.

Can you compare cap rates across different property types? You can compare cap rates across property types, but do so with context. A 6.0% cap rate on a multifamily property represents a very different risk profile than a 6.0% cap rate on a single-tenant office building. Always consider the underlying risk factors, growth potential, and market dynamics when making cross-type comparisons.

What is the difference between going-in cap rate and exit cap rate? The going-in cap rate uses current NOI at acquisition divided by the purchase price. The exit cap rate is the projected cap rate at the time of sale, used to estimate future resale value. Investors typically assume an exit cap rate 50 to 100 basis points higher than the going-in cap rate to build in a conservative buffer for market shifts.

Sources?

1. National Council of Real Estate Investment Fiduciaries (NCREIF), Property Index Returns and Cap Rate Data, Q4 2025.
2. CBRE Research, U.S. Cap Rate Survey, Second Half 2025.
3. Moody's Analytics CRE, Commercial Property Price Indices and Cap Rate Trends, January 2026.
4. Federal Reserve Economic Data (FRED), 10-Year Treasury Constant Maturity Rate, 2020 to 2026.
5. Real Capital Analytics (RCA), U.S. Capital Trends, Commercial Real Estate Transaction Volume and Pricing, 2025.

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