Understanding Cap Rate: The Most Important Real Estate Investment Metric

                                       

By: Christopher Gati

Director, Assurance

Every real estate investor eventually encounters the moment when broker marketing materials, appraisal reports, and investment committee memos all converge on one number: the cap rate. “Property trades at a 6.2% cap.” “Market cap rates compressed 50 basis points.” “We’re targeting 7.5% stabilized cap.”

These statements presume everyone agrees on what cap rates mean and how to use them. Reality? Most investors apply cap rates mechanically without understanding what drives them, when they’re useful, and when they’re dangerously misleading.

Key Takeaways

• Cap rates measure unlevered operating yield only: Net operating income divided by property value—ignoring financing, appreciation, and capital costs that determine actual returns
• Market cap rates establish relative value baselines: Properties trading below market cap rates are expensive; properties trading above market cap rates are cheap—unless property-specific factors justify the differential
• 50-basis-point cap rate variance creates millions in valuation impact: On a $10 million NOI property, 6.0% versus 6.5% cap rate equals a $13 million price difference
• Bottom Line: Cap rates provide market context and quick valuation estimates but can’t substitute for comprehensive investment analysis—properties with identical cap rates deliver radically different returns based on factors cap rate calculations ignore.

Why Cap Rates Dominate Real Estate Conversation

Cap rates reduce complex properties into single comparable metrics. An office building in Atlanta generating $900,000 NOI and trading at a 7% cap rate might be compared directly to a retail center in Phoenix generating $1 million NOI at a 6.5% cap rate—even though they’re completely different properties in different markets.

This comparability makes cap rates indispensable for market analysis, portfolio benchmarking, and quick screening. But comparability creates false precision—treating dissimilar properties as equivalent because they share the same cap rate.

Cap Rate’s Core Function

Translating operating income into property values and vice versa. If you know market cap rates are 6%, and a property generates $500,000 NOI, you instantly know the approximate value is $8.3 million. If someone asks $10 million, you know they’re pricing at a 5% cap and are more bullish on the property. 

This valuation shorthand enables rapid investment screening. Review 50 opportunities, eliminate 40 immediately based on cap rate versus asking price analysis, then dive deep into the remaining 10.

Reading Market Cap Rate Signals

Cap rates signal market perception of risk and growth potential more accurately than any survey or analyst report.

When Cap Rates Compress (Decrease)

Investors perceive lower risk or expect higher growth. Willingness to accept lower yields indicates confidence in property performance and in the appreciation of exit value. Competition intensifies for quality assets.

Example: Multifamily cap rates in Sunbelt markets compressed from 5.5% to 4.2% between 2019 and 2021 as investors priced in rental growth expectations and population migration trends.

When Cap Rates Expand (Increase)

Risk perception increases or growth expectations decline. Required returns rise to compensate for uncertainty. Transaction volume typically decreases as buyers and sellers disagree on appropriate pricing.

Example: Office cap rates expanded from 6.5% to 8.5%+ in many markets post-2020 as remote work trends created uncertainty about long-term office demand and tenant retention.

The Interest Rate Connection

Cap rates don’t move mechanically with interest rates, but the relationship matters. When 10-year Treasury yields sat at 1.5%, investors accepted 4.5% multifamily cap rates—a 300-basis-point spread. With Treasuries at 4.5%, accepting 4.5% cap rates makes no sense—real estate carries operational risk, illiquidity, and management requirements that bonds don’t.

Historical spreads between cap rates and risk-free rates typically range from 200 to 400 basis points. When spreads compress below 200 basis points, real estate becomes overvalued relative to other asset classes. When spreads exceed 500 basis points, real estate offers compelling relative value.

Property-Level Cap Rate Analysis: Beyond the Number

Two properties trading at identical 6.5% cap rates can represent completely different investment opportunities once you examine what drives the NOI.

Tenant Credit Quality

Property A: Three investment-grade tenants on 10-year triple-net leases with 2.5% annual escalations. Minimal landlord responsibilities, predictable cash flow, low rollover risk.

Property B: 15 local tenants on 3-5 year leases with flat rents. The landlord is responsible for substantial operating expenses, high lease administration costs, and uncertain renewals.

Both might justify 6.5% cap rates in their respective markets, but they’re not comparable risks. Property A deserves premium pricing (a lower cap rate) due to its income stability. If both trade at 6.5%, Property A is expensive and Property B is cheap.

Capital Expenditure Requirements

Cap rate calculations use NOI, which excludes capital expenditures. Properties with identical NOI but vastly different capital needs produce different actual returns.

Property with aging HVAC systems, deteriorating roofs, and outdated parking lots has the same cap rate as newly renovated comparable—until you account for $2 million in deferred maintenance. The effective cap rate after capital costs is substantially lower.

Conservative investors underwrite “economic cap rates” that include capital reserve allocations in the denominator, providing clearer pictures of actual property-level returns.

Using Cap Rates for Acquisition Screening

Cap rates enable efficient deal screening in three steps:

Step 1: Establish Market Baseline

Research comparable sales in the target market for similar property types. Grocery-anchored retail in your market trades at cap rates of 6.5-7.0% based on recent transactions.

Step 2: Compare Offering to Market

Target property asks $15 million with $1 million NOI—6.67% cap rate. Falls within market range, passes initial screen.

Step 3: Identify Factors Justifying Deviation

If property trades below market cap rates (lower yield, higher price): What justifies premium pricing? Superior location, credit tenants, long lease terms, recently renovated?

If property trades above market cap rates (higher yield, lower price): What explains the discount? Deferred maintenance, tenant rollover risk, secondary location, functional obsolescence?

Properties priced at market cap rates deserve standard diligence. Properties priced at premiums or discounts to market require explanation—either the seller is mispricing the asset (opportunity) or property-specific factors justify the differential (trap).

The Exit Cap Rate Assumption: Where Projections Live or Die

Most investment analysis projects span 5-10 years, requiring exit-value assumptions to calculate IRR and equity multiples. Exit values typically derive from terminal cap rate assumptions applied to projected future NOI.

Terminal Cap Rate Selection Matters Enormously

Acquire property at 7.0% going-in cap rate. Project NOI growth to $1.5 million by year 7.

Terminal cap rate at 7.0%: Exit value = $21.4 million Terminal cap rate at 7.5%: Exit value = $20.0 million
Terminal cap rate at 8.0%: Exit value = $18.75 million

That 100-basis-point terminal cap rate variance creates a $2.65 million difference in exit value—often representing 30-50% of projected IRR.

Aggressive underwriting assumes terminal cap rates equal to or below going-in cap rates, implying risk decreases over time. Conservative underwriting assumes terminal cap rates 25-50 basis points above going-in rates, reflecting property aging and market uncertainty.

Cap Rate Intel for Property Investors

Cap rates provide a common language for discussing relative value across markets and property types. They enable quick valuation estimates and efficient deal screening. They signal market sentiment about risk and growth.

But cap rates are starting points, not conclusions. Properties with identical cap rates deliver different returns based on leverage, capital requirements, lease rollover timing, repositioning potential, and market positioning.

Sophisticated investors use cap rates to establish market context, identify potential mispricing, and frame valuation discussions—then conduct comprehensive analysis examining factors cap rates ignore.

Use cap rates strategically. Don’t go for it blindly.

Wiss provides comprehensive real estate investment advisory services – connect with us to learn more. 

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