Cap rate is usually the first number an investor asks about — and the one they most often misread. The instinct is to treat it like a grade: a low cap rate means the deal is expensive, a high one means you’re getting a bargain. It doesn’t work that way. A cap rate isn’t a verdict on a deal. It’s a starting point — and on its own, it tells you almost nothing about the viability of a deal.
Start With the Formula
Cap rate stands for capitalization rate, and the formula is simple: net operating income (NOI) divided by purchase price.
If a building produces $100,000 in annual NOI and sells for $1 million, the cap rate is 10%. If that same $100,000 of income sells for $1.25 million instead, the cap rate is 8%.
Here’s the math:
$100,000 NOI / $1,000,000 purchase price = 10% cap rate.
The more you pay for the same income, the lower the cap rate.
It works in reverse too. See a property listed at $2 million on an 8% cap rate, and you can back into the income:
$2 million × 8% = $160,000 of NOI.
It’s simple algebra — with any two of the three numbers, you can solve for the third.
What a Cap Rate Actually Measures
A cap rate tells you what you’re paying for every dollar of income a property produces from operations — before debt, interest costs, capital expenditures, depreciation, and income taxes.
That’s its real usefulness: it lets investors compare deals side by side, at scale, based purely on the income each property generates. It strips out the financing and asks one clean question — how much am I paying for this income stream?
What a Cap Rate Doesn’t Tell You
A cap rate is a headline number, and the real story is in the details it leaves out. It won’t tell you:
- Who the tenant is, or how creditworthy they are
- How long the leases run
- Whether the rent is above or below market
- What happens to your income if the tenant leaves
- How much capital the building will need — next year, or to find a new tenant if the anchor moves out
The key question for any investor is this: are you more concerned with what the property produces on day one, or with what your income looks like over the next five to ten years?
The cap rate tells you where you’re starting. But whether a deal is a good investment has very little to do with where you start and everything to do with where you end up.
Price and Cap Rate Move in Opposite Directions
The lower the cap rate, the higher the price. The higher the cap rate, the lower the price.
$100,000 NOI / 7% cap rate = $1.43 million purchase price
$100,000 NOI / 6% cap rate = $1.67 million purchase price
So why would anyone pay up for a lower cap rate — or demand a higher one? It comes down to two things: perceived risk and expected future performance.
Risk Is What Sets the Cap Rate
Take two identical 3,000-square-foot single-tenant retail buildings, each producing $100,000 in NOI. The only difference is who’s inside.
- Building A — Starbucks, 15-year lease: sells at a 5% cap rate, or $2 million.
- Building B — a local coffee shop, two years left, shaky financials: sells at an 8% cap rate, or $1.25 million.
These two properties with the same income have a $750,000 difference in value.
Starbucks is a hundred-billion-dollar company — the rent is getting paid.
The local shop might be a couple of bad months from closing. And even if it survives, it may decide not to renew.
If that tenant leaves, you’re staring at vacancy, lost income, tenant improvement costs, leasing commissions, and the time it takes to fill the space.
More risk drives the cap rate up, which drives the value down.
Asset Type Moves the Cap Rate Too
Risk isn’t only about the tenant — it’s about investor demand for the property type.
Picture two buildings next door to each other, both 90% leased, both producing $100,000 in NOI.
- Industrial park: 6.5% cap rate, or about $1.54 million (100,000 NOI / 6.5% cap rate = $1.54 million purchase price)
- Multi-tenant office: 10% cap rate, or $1 million ($100,000 NOI / 10% cap rate = $1 million purchase price.
Despite being on the same street and producing the same income, these two properties have a $540,000 difference in value, with the office worth roughly 35% less.
Why? Industrial is in favor: rents have been rising, vacancies lease quickly, and buildout costs to attract tenants are minimal. It reads as low-friction, stable income.
Office is out of favor: vacancies can sit for years, there’s more supply than demand, and landlords often have to provide significant concession packages — free rent, large tenant-improvement allowances — to attract tenants.
Buyers demand a higher return to take on that risk, and that shows up as a higher cap rate.
Cap Rates Follow Interest Rates
Cap rates don’t move in a vacuum — they track the cost of capital. From 2020 to 2022, when interest rates were near zero and lenders were eager to lend, cap rates compressed and property values climbed.
Since 2022, as rates have risen and lenders have pulled back, cap rates have moved higher and values have softened.
Fewer buyers + higher borrowing costs = lower prices
The takeaway: don’t just compare a deal’s cap rate to other current listings. Compare it to where cap rates have historically been for that asset type, that tenant profile, and that specific market and neighborhood..
Where Investors Get Into Trouble
The mistake is treating the cap rate as the only number that matters. I’ve watched investors buy at a 7.5% cap rate convinced they got a great deal — then a year later the largest tenant moves out. Income drops, it takes a couple of years to land a replacement, and hey’re hit with a large bill for tenant improvements and commissions.
The cap rate looked great, but they didn’t factor for the risk associated with the cap rate.
The Bottom Line
A cap rate is a tool for evaluating income-producing property at a high level — a starting point.
Two properties with identical income can carry drastically different values.
Income that’s perceived as stable and predictable commands a higher price and a lower cap rate; income wrapped in risk and uncertainty trades at a lower price and a higher cap rate.
So the next time you look at a deal, don’t just ask what the cap rate is. Ask why it’s priced where it is — the risk, the tenancy, the asset type, and the market fundamentals behind the number.