Understanding CAP Rate: What Every Commercial Real Estate Investor Should Know

RAI Commercial Group
Jul 15
3 min read

In commercial real estate, few terms are as widely used—or as widely misunderstood—as “CAP rate.” Whether you’re evaluating a multifamily asset, a flex warehouse, or a mixed-use development, the capitalization rate (CAP rate) is a foundational metric that offers a quick snapshot of a property’s potential return. But it’s not just a number—it’s a lens through which savvy investors assess value, risk, and market position.

Let’s break it down.

What Is a CAP Rate?

The capitalization rate, or CAP rate, is the ratio of a property's net operating income (NOI) to its purchase price (or current market value). It reflects the yield an investor might expect on an all-cash purchase, before financing, taxes, or capital expenditures are factored in.

Formula:

CAP Rate = Net Operating Income (NOI) ÷ Purchase Price

Example: If a property produces $100,000 in annual NOI and is priced at $1,250,000:

CAP Rate = $100,000 ÷ $1,250,000 = 8%

What Does the CAP Rate Tell You?

CAP rate is commonly used to:

Compare Properties: A quick benchmark to evaluate similar assets across submarkets.
Gauge Market Trends: Rising or falling CAP rates often reflect shifts in supply, demand, or investor sentiment.
Assess Risk: Generally, higher CAP rates imply higher risk and lower property prices, while lower CAP rates suggest lower risk and higher valuation.

But remember: CAP rate alone doesn’t tell the whole story. It must be weighed against location, tenant quality, lease terms, asset condition, and long-term growth potential.

How to Interpret CAP Rates Across Asset Classes

CAP rates vary by asset type, geography, and market cycle. Here's a rough overview:

Asset Type	Typical CAP Rate Range
Core Multifamily	4.0% – 5.5%
Value-Add Multifamily	6.0% – 7.5%
Retail (Urban)	5.0% – 6.5%
Flex / Industrial	6.0% – 8.0%
Office Condos	7.0% – 9.0%
Triple Net (NNN)	5.0% – 6.5%

CAP rates compress in hot markets or for trophy assets, and expand in secondary markets or for destabilized deals.

What Influences a Property’s CAP Rate?

Several factors shape a property’s CAP rate:

Location & Demographics
Tenant Stability & Lease Terms
Asset Age & Condition
Market Vacancy Rates
Interest Rate Environment
Perceived Risk & Demand for Capital

Pro tip: Don’t confuse in-place CAP rate (based on current income) with pro forma CAP rate (based on projected stabilized income). Know which you’re looking at.

CAP Rate ≠ Cash Flow

It’s a common mistake to treat CAP rate as cash-on-cash return. But CAP rate ignores financing, while cash-on-cash return factors in mortgage payments. CAP rate is a starting point. Your actual return depends on:

Debt terms
Tax strategies
Capital expenditures
Exit plans

When to Use CAP Rate—and When Not To

Use CAP Rate to:

Compare stabilized assets
Analyze market pricing trends
Estimate quick valuations

Don’t rely solely on CAP Rate when:

Evaluating value-add or redevelopment deals
Assessing properties with irregular income or OPEX
Factoring in tax benefits or debt leverage

Final Word

CAP rate is a powerful metric—but only when used wisely. It offers a valuable shorthand for comparing deals and understanding risk, but it’s not the final word in deal analysis. For the informed investor, it’s a conversation starter, not a deal-closer.

Understanding CAP rate—its strengths, its limitations, and its context—sets the foundation for smarter, more strategic investing.

Invest Smarter with RAI Commercial Group

At RAI Commercial Group, we help our clients move beyond the surface numbers. Whether you’re building a portfolio, entering a new asset class, or repositioning for long-term yield, our data-backed strategies and boutique approach put you in the driver’s seat.

Let’s talk CAP rates, cash flow, and custom strategies. Book a strategy call here.

Written by RAI Commercial Group