Cap rate, in one step.

How cap rate prices a property

Cap rate is NOI divided by value. A property with $700,000 of NOI at a 7% cap rate is worth $10M. Run it the other way, dividing NOI by a market cap rate, and you get an implied value.

Small cap rate moves swing value hard: the same $700,000 NOI at 6% is worth about $11.7M. That sensitivity is why appraisal review scrutinizes where the cap rate came from.

What a lender does with it

Lenders treat the appraisal's cap rate as an input to check, not a given, asking whether the comparable sales actually compare and whether the rate reflects current market conditions.

Cap rate feeds value, and value feeds LTV, so an optimistic cap rate flows straight into leverage.

How to calculate a cap rate, step by step

Cap rate is net operating income divided by property value. The arithmetic is one division. The work is in getting the NOI right, because every input error flows straight into the value.

Start with gross potential rent, subtract vacancy and collection loss, and add other income such as parking or fees to reach effective gross income. Subtract operating expenses, meaning taxes, insurance, utilities, repairs, payroll and management, to reach NOI. Debt service, depreciation and income taxes stay out.

A worked example. A building with $1,400,000 of effective gross income and $560,000 of operating expenses has NOI of $840,000. If it sells for $12,000,000, the cap rate is $840,000 divided by $12,000,000, or 7 percent. Rearranged, a buyer who wants a 7 percent cap rate on that income would pay $840,000 divided by 0.07, which is $12,000,000.

What a cap rate means in dollars

The same income is worth very different amounts at different cap rates, which is the whole reason cap rates are argued over. The table holds NOI fixed at $100,000 and changes only the cap rate.

The last column is the useful one. A cap rate is the inverse of a price multiple: at 5 percent a buyer pays twenty times the property's annual income, and at 8 percent, twelve and a half times. Small moves in the cap rate are large moves in value, which is why a quarter point is worth a long negotiation.

Going-in, exit and stressed cap rates

Underwriting uses three cap rates, not one. The going-in cap rate is today's NOI over today's price. The exit cap rate is the rate assumed when the property is sold or refinanced later, and it is normally set at or above the going-in rate, because the building will be older and the market may be less generous. Assuming the exit rate falls is assuming the market will pay for the business plan.

Lenders add a third. To size or stress a loan they often value the property at a cap rate above the appraisal's, and ask whether the loan still holds up. That stressed value matters most at maturity, when the loan has to be refinanced at whatever cap rates and interest rates then prevail.

A cap rate is not your return

A cap rate describes the property, unlevered. It ignores how the purchase is financed, so it is not the return an investor actually earns. Cash-on-cash return measures levered cash flow against the equity put in. IRR adds timing and the eventual sale.

The comparison that matters with debt is the cap rate against the loan's debt constant, meaning annual debt service divided by the loan amount. When the cap rate is higher, borrowing raises the equity return, which is positive leverage. When the debt constant is higher, every borrowed dollar costs more than the property earns on it, and leverage drags the return down.

Mistakes that move the number

Using pro forma NOI. A cap rate on income the property has not yet earned describes a plan, not a building. Use in-place or trailing twelve month NOI unless the comparison is explicitly forward-looking.

Including debt service or capital expenditures in operating expenses. Both sit below NOI. Leaving out a management fee because the owner self-manages has the opposite effect, overstating NOI, and lenders put the fee back in.

Comparing an asking price cap rate with closed sales. The asking price is a seller's opening position. Compare like with like.

Not to be confused with an interest rate cap

Search results for cap rate calculators often mix in interest rate cap calculators, because the words are the same. They have nothing to do with each other. A capitalization rate prices a property's income. An interest rate cap is a hedge a floating-rate borrower buys to limit how high its loan rate can go, and lenders frequently require one on bridge and construction loans. Both are defined in the glossary, linked below.