Are you looking into commercial real estate and wanted to know what a cap rate is? In this post, I’ll define what cap rate is – and more importantly – what capitalization rate isn’t and what most people get completely wrong about it.

I’ll also walk you through some examples to drive my point home, which is:

• Cap rate is not a measurement of your return on money, and it should not be viewed as “what would my return be if I paid for the property in all cash.”

What Is Cap Rate

The formula for cap rate (or capitalization rate) in commercial real estate is:

Cap Rate = NOI / Market Value

You can think of it as an agreed upon acceptable return rate, based on where the real estate is located.

For example, in very rough neighborhoods, cap rate might be very high because investors require a higher return on investment to compensate for the risk (i.e. a 10% cap). Conversely, in NYC the market might agree that it should “trade at a 3% cap” because it’s a safer investment.

Keep in mind that despite my use of the word “return” above, you should not think of cap rate as a return on your money. You should only think of capitalization rates as a NOI-to-Market Value ratio that the market agrees to trade at. More on this on the next section.

For now, you should think of cap rate as simply a rating of how good/bad your real estate market is. Example:

• 8-10%: crappy market, risky investment.
• 6-8%: decent market, middle of the road investment.
• 3-5%: premium market, safer investment.

What Cap Rate Isn’t And What Everyone Gets Wrong About It

Capitalization rate is not a measurement of return (i.e. it says nothing about how much money you’ll get back given the money you’ve put in)!

Anyone that says “oh yeah given this cap rate I’m expecting X amount of returns’ has no idea what they’re talking about. Hide your money and your bank account and run away from those people.

Seeing it as a rate of return makes no sense, because a lot of commercial projects you invest in will have some forced appreciation. Let me run through an example to show you what I mean.

• We have an equation of Cap Rate = NOI / Market Value
• Let’s turn it on its head and look at it like this instead: Market Value = NOI / Cap Rate, where cap rate is held constant and market value goes up or down with NOI.
• Say you had an NOI of $1 million for a property and its market value is $25 million. You’d have a market capitalization rate of 4%.
• Say you spend a bunch of money hiring new property managers and improved the asset to an NOI of $2 million.
• Because the capitalization rate is the agreed upon market ratio between NOI and market value, your property is now worth $50 million.
• If you sell the property for $50 million, you’ve made a lot of money.
• But your capitalization rate is still 4% regardless of whether or not you increased your NOI.

In the above example, your rate of return increased drastically after you’ve put the hard work in to increase your NOI. The market value goes up with NOI, and the cap rate is constant.

In this case, the capitalization rate would reflect what the market wants to trade property at, and doesn’t really change based on any actions you take.

Why Cap Rate Doesn’t Incorporate Financing

Some define capitalization rate as “the return you’d get if you paid for the property in all cash.”

This makes no sense, as most real estate transactions (especially large commercial ones, where cap rate actually matters) is paid with financing.

So why doesn’t it incorporate financing into its equation? Because capitalization rate only measures market sentiment, and is not a metric for financial return!

If cap rate is actually a rate of return on your money, it makes sense most logically to account for the debt service (i.e. cash-on-cash does this).

But capitalization rate NEVER has any debt service involved in its calculation.

The reason’s because every developer can borrow money and finance their project differently, and the cap rate needs to be an agreed-upon metric in the market to determine a property’s value based on its NOI. Example:

• Alice wants to buy a $10 million property with a 5% cap ($500K NOI), with all cash. In her specific case, she is getting a 5% return on her money.
• Bob wants to buy the same property, but requires a debt service of $300K each year. His NOI would be $200K. If you naively plugged it into the equation of cap rate, you’d find that the cap is now 2%.
• But that makes no sense! The property’s cap rate and market sentiment towards that real estate market doesn’t become 2.5X as optimistic just because Bob wants to use a different financing scheme. “Twice as optimistic” because a cap of 2% would mean a dollar of NOI increase would give you 2.5X more dollars than if you were to increase a dollar of NOI in a 5% cap property.

What Moves Capitalization Rates Then? It Being Constant Doesn’t Seem Realistic

Yes, capitalization rates in real estate markets move up and down. The above example had the cap rate held constant so I can better drive home my point.

Cap rates change, but it goes up or down not because of what you do for the property. It doesn’t care what actions you take.

Cap rates change based on external market forces and the overall sentiment of the subject real estate market.

This is why cap rates should only be used as a market sentiment measurement. Measuring a return on your money accounts for both: 1) things you are in control of to drive value up, and 2) things you can’t control like market forces. Cap rate only accounts for 2). Example:

• Alice bought a $10 million property with a 5% cap rate ($500K NOI). Nothing’s changed. But the sentiment towards her market is very optimistic. The cap rate compresses to 4% due to market sentiment. Her property is now worth $500e3/.04 =  $12.5M. She got a $2.5M gain for doing nothing.
• Bob bought a $10 million property with a 5% cap rate. He increases the $500K NOI to $600K NOI. Normally, this would mean his property is now worth $12M. Unfortunately, the market is pessimistic about the area Bob’s invested in. Cap rate jumps to 8%. His property is actually worth less now (600e3/.08 = $7.5M) than Alice’s.

So, cap rates can change your return on your money but as a number by itself tells you nothing.

And conflating capitalization rates as an “approximate cash-on-cash” is poorly informed because just look at the previous example: an increase in cap rate along with an increase in NOI resulted in a lower property value.

Likewise, a lot of forced appreciation commercial projects have fewer expenses after year 2 or year 3. This is orthogonal to capitalization rate, which can stay the same. Thus, your cash-on-cash can skyrocket in year 4 while cap rate remains constant, goes down, or goes up.

Summary, And What Are Good Metrics On My Return On Money?

Here’s the cliff notes on what cap rate is.

• An agreed upon NOI-to-market value ratio within a real estate market.
• It changes based on external factors, and not anything any individual investor can control.
• NOT a return-on-investment metric. And if you’re an investing looking for a metric to see how much ROI you’d get, do NOT look at cap rate.

If you’re a dividend investor, you should look at cash-on-cash as a financial metric. This is because CoC takes into account debt service, refinances, expenses, etc.

If you’re looking for appreciation, look for equity multiples or IRR.

At the end, you can choose to misinterpret cap rates if you want, but if you’re investing in any syndication deals you wouldn’t be able to think about the document or the math properly.

For example, if a syndicator says there should be some cap compression from 6.5% to 6% over the next 3 years, you’ll think that’s a bad thing because “the % is going down”. In reality, it’s a great thing because if NOI doesn’t move at all, you’ll get a tailwind of an extra 8% in your real estate investment’s valuation.

Further, understanding this stuff helps you make good investment decisions. It’s one thing for bloggers and Investopedia to get cap rate completely wrong, but if you’re reading a document from a syndicator asking you for 100K and they use the term synonymously as financial return…then you know to run away.

PS: For a LOT more details on commercial real estate math, grab Brian Burke’s Hands Off Investor. If you’re serious about investing in real estate, you must understand the numbers. Otherwise, you’ll lose tons of money. This book provides simple, intuitive explanations of cap rate + bunch of other numbers. Also, I get a tiny commission so I can buy half a Starbucks.