Cap Rate Analysis
Cap Rate Explained: How Real Estate Investors Actually Use It
Cap rate is the most quoted and most misunderstood number in commercial real estate. A plain-English walkthrough of how cap rates are built, what they actually price, and where they mislead.
The Formula in One Line
Cap rate equals Net Operating Income (NOI) divided by Purchase Price. A $1,000,000 building producing $70,000 of NOI trades at a 7.0% cap rate. That is the entire equation. Everything else is judgment about the inputs.
The simplicity is the trap. Two buyers can look at the same property and produce cap rates 100 basis points apart, because they disagree on what belongs in NOI, what rent is sustainable, and what reserves are realistic.
What Belongs in NOI
NOI is income after operating expenses but before debt service, capital expenditures, depreciation, and income tax. Operating expenses include property taxes, insurance, utilities, repairs and maintenance, management fees, payroll for on-site staff, marketing, and a reasonable reserve.
A lot of seller pro formas exclude management fees, understate insurance, or use stale tax bills. Underwrite to a fresh number: re-assessment after sale, current-quote insurance, market-rate management, and a reserve of $250 to $400 per unit for multifamily or $0.15 to $0.40 per square foot for commercial.
Going-In vs. Stabilized vs. Exit Cap
Going-in cap rate uses trailing or in-place NOI on day one. Stabilized cap rate uses NOI after the business plan plays out (leased-up, renovated, re-tenanted). Exit cap rate is the rate a future buyer is assumed to pay at sale.
Disciplined underwriting always shows a positive spread between exit cap and going-in cap (in other words, exiting at a higher cap than buying). If a model relies on cap rate compression to make returns work, it is not really a real estate model. It is a bet on interest rates.
How Cap Rates Relate to Interest Rates
Cap rates do not move one-for-one with the 10-year Treasury, but they are tethered to it through the risk premium investors demand over a risk-free yield. When the 10-year rises 150 basis points, cap rates eventually follow, usually with a lag of two to four quarters.
The spread between cap rate and debt cost (the positive leverage gap) is what makes financed real estate work. When debt costs the same as the cap rate, leverage stops adding return and starts adding only risk.
Where Cap Rate Misleads
Cap rate prices in-place income. It says nothing about future capex, lease rollover concentration, environmental liability, or the strength of the submarket. A 9% cap on a single-tenant building with two years of lease term left is not really a 9% deal. It is a leasing assignment dressed up as a yield.
We use cap rate as a quick triage filter, not a decision tool. The real decision rests on unlevered IRR, cash-on-cash through the hold, debt yield, and a stress test on rent and exit.
How Price Capital Group Underwrites Cap Rate
Our acquisitions team rebuilds NOI from the rent roll up, re-quotes insurance and taxes, and benchmarks operating expenses against comparable assets we already manage. We then triangulate value across cap rate, price per door or per square foot, and replacement cost.
If your South Florida property is under consideration for sale, we will share our underwriting approach openly. Sellers transact more confidently when they understand how the buyer arrived at the number.
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