What Is a Capitalization Rate and How Does It Work?

Estimating a residential property’s value, even ones in distressed condition or of unique profiles, is pretty simple: you look at the sale prices of similar properties, make some adjustments for condition, style, and location, and there’s your number.

However, it’s not as straightforward with commercial properties. Finding “comps” for commercial properties can be quite a bit more complicated since they come in many more sizes and configurations than a one-, two- or three-bedroom house. This is why commercial investors use cap rates (short for capitalization rates) to gauge the quality of an investment.

But what is a cap rate, how is it used, and how is it calculated? Let’s cover those questions and a few more below.

What Is a Cap Rate?

A cap rate is a number that tells an investor what kind of return they can expect on the investment property and how long it’ll take for them to make back the purchase price. From there, they can also make certain assumptions about the investment’s risk and overall quality.

Cap rates take a property’s net operating income (NOI), the money you’ll make from the property minus any operating expense, and divide it by its purchase price.

So let’s say you’re looking at an apartment building with a price of $10 million. You project that you’ll take in $900,000 in rent with $150,000 of expenses, leaving you with a net operating income (NOI) of $750,000. Dividing that by $10 million gets you a cap rate of 7%.

So what does a cap rate of 7% (or any other percentage) mean?

Interpreting Cap Rate

Low cap rates mean you’ll have lower risk and higher value, though lower cash flow. Higher rates mean you’ll have higher returns, with higher risk and a lower price.

Properties with low cap rates (3-5%) tend to be Class A or B: new construction, good amenities, located in central, desirable locations. Think of a luxury apartment building in Manhattan — high rents, high expenses, but low risk, with very healthy and rapid appreciation.

On the other hand, properties with very high cap rates (more than 8%) tend to be Class C or D properties — older properties that may need repairs, have few or no amenities, and are in less-than-desirable locations with little access to things like good schools or commercial areas. Think of a rural mobile home park: lots of cash rents, few expenses, but high tenant turnover and little potential for meaningful long-term appreciation.

Of course, differences in market and geography can make a big difference. A 6% cap rate for an office building in downtown Nashville, Tennessee, is a lot different than a 6% cap for a warehouse in small-town Wyoming. But these general guidelines are relatively accurate, and a simple, all-inclusive metric is necessary in situations where, for example, you’re trying to convince someone to give you a loan for an investment.

Is a High Cap Rate Better Than a Low Cap Rate?

Asking if a high cap rate is better than a low cap rate is like asking if vanilla ice cream is better than chocolate ice cream — it all depends on your preferences!

If you’re a very long-term real estate investor with a surplus of patience — a “buy and hold” type — you’ll likely want to target properties with low cap rates. While these properties will yield relatively lower cash flows, they’ll see significant increases in value over time, and they’re very safe investments.

Since they’re in high-demand areas, there are few vacancies, so your cash flow is highly predictable, albeit low. Your profits here will be through the equity you build as the property increases in value. And don’t forget — you can improve these properties and raise the rents, which will raise your ROI!

On the other hand, if you’re an investor who wants a “quick win” and prioritizes cash flow, you should target properties with higher cap rates. For example, a Class C apartment building with a cap rate of 10% will consistently bring in a good amount of cash.

However, due to location and tenant profile, the rent and the property value won’t have a lot of room to grow, even if you make significant improvements to the property. A high-cap property is a classic “high floor, low ceiling” situation.

What is Cap Rate Compression?

You can change your property’s cap rate by increasing or decreasing the rent — or market conditions can alter your property’s cap rate.

When property values go up (as they have been for the past several years) but cash flows remain the same, cap rates go down. This is called cap rate compression; a compressed cap rate isn’t necessarily the same as a low cap rate.

Cap rates become compressed when lots of money enters the market, bidding up prices. This creates a strong seller’s market that can price out a lot of investors looking to buy into the market. As prices continue to go up, but NOI stays the same, yields drop.

When yields drop to market interest rates or below, investors must pay cash for their investments. Investors unable to do so are locked out of the market, thus cooling demand. And when demand cools, prices tend to drop — a situation that we’re likely approaching in the residential real estate market as the effect of higher interest rates filters through the market.

In these circumstances, a low cap rate isn’t an indicator of a safe, solid, low-risk investment — it’s an indicator of a potentially overpriced market approaching its peak. The trick, of course, is being able to tell the difference between a low cap rate and a compressed one. It’s not always easy, especially in an uncertain economy. Still, looking at cap rates is one vital tool in a savvy investor’s toolbox.