Capitalization rate — universally called the 'cap rate' — is the most widely used metric in commercial real estate valuation. It expresses the relationship between a property's net operating income (NOI) and its market value. Understanding cap rates is essential for evaluating investment properties, comparing markets, and understanding how lenders underwrite commercial loans.
Cap Rate = Net Operating Income (NOI) ÷ Property Value (or Purchase Price). Example: A property generates $120,000 in annual NOI and is priced at $1,500,000. Cap rate = $120,000 ÷ $1,500,000 = 8.0%. NOI is calculated by subtracting all operating expenses (property taxes, insurance, maintenance, management fees, utilities, reserves) from gross rental income. NOI does NOT include mortgage payments — cap rate is a pre-debt metric that allows apples-to-apples comparison regardless of financing structure.
A cap rate represents the unlevered yield an investor receives if they bought a property all-cash. Higher cap rates generally indicate higher risk or lower-demand markets. Lower cap rates indicate lower risk, higher demand, or stronger credit tenants. For example: A 4% cap rate in Manhattan reflects premium pricing for stable, high-demand assets. An 8% cap rate in a secondary market reflects higher risk and return expectations. Cap rates also move inversely with property values — as prices rise, cap rates compress; as prices fall, cap rates expand.
Commercial real estate lenders use market cap rates to derive property value independent of the purchase price. This is critical when a buyer overpays or when a seller's stated NOI is inflated. Lenders apply a market cap rate to the actual verified NOI to arrive at their own appraised value, which then becomes the basis for LTV calculations. If a lender applies a 7.0% cap rate to $100,000 NOI, the derived value is $1,428,571 — regardless of what the buyer agreed to pay.
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