Capitalization rates are one of the most commonly used and most frequently misunderstood metrics in real estate. At a basic level, a cap rate expresses the relationship between a property’s income and its price. In practice, it is a shorthand for how much income the market demands for owning a given stream of cash flow under a given set of risks.
Cap rates do not tell you what a property is worth in isolation. They tell you how income is being priced relative to alternatives.
What Is a Cap Rate?
The cap rate is calculated as net operating income divided by value:
If a property produces $100,000 of NOI and trades for $2,000,000, the implied cap rate is 5 percent. That number reflects how much unlevered income the buyer is receiving relative to the purchase price.
Importantly, cap rates are unlevered. They ignore financing entirely. They describe the asset, not the equity structure layered on top of it.
What Cap Rates Are Trying to Price
Cap rates embed several things at once. They reflect expectations around income durability, growth, operating risk, liquidity, and the opportunity cost of capital. When buyers accept lower cap rates, they are accepting less current income in exchange for perceived stability, growth, or scarcity. When buyers demand higher cap rates, they are asking to be compensated for uncertainty, volatility, or execution risk.
This is why two properties with identical NOI can trade at very different cap rates. Location quality, tenant profile, lease structure, asset age, regulatory exposure, and market liquidity all affect how income is valued.
Why Cap Rates Move
Cap rates are not static. They move as conditions change.
Interest rates matter because they influence the cost of capital and investor alternatives. When risk-free or low-risk yields rise, buyers generally require higher returns from real estate income, putting upward pressure on cap rates. When rates fall, cap rates often compress, though not always proportionally.
Growth expectations also matter. Assets with credible, visible income growth often trade at lower cap rates because buyers are willing to accept lower current yield in anticipation of higher future NOI. Conversely, assets with capped or uncertain growth require higher initial yields.
Liquidity matters as well. Markets with deep buyer pools and readily available financing tend to support lower cap rates than markets where exits are uncertain or financing is episodic.
Cap Rates vs. Yields
A common mistake is treating cap rates as investment returns. They are not. A cap rate describes the yield on current income at a point in time. Total return depends on what happens next: income growth, expense control, financing terms, and exit pricing.
A property purchased at a 6 percent cap can produce a higher total return than one purchased at an 8 percent cap if income grows meaningfully or if the exit environment improves. The reverse is also true. Cap rates are a starting point, not a conclusion.
Going-In Cap Rate vs. Exit Cap Rate
Underwriting typically involves at least two cap rates: the going-in cap rate and the exit cap rate.
The going-in cap rate reflects the price paid for current income. It is observable and concrete.
The exit cap rate is an assumption about how future income will be valued at sale. It is not observable. It must be chosen deliberately.
Exit cap rates should generally be more conservative than going-in cap rates. They are applied to income several years in the future, in an unknown capital market environment. Small changes in exit cap assumptions can overwhelm years of operating performance, especially in deals where most of the return comes from the sale.
Why Cap Rates Matter So Much in Valuation
Cap rates are powerful because valuation is highly sensitive to them.
If NOI is $120,000:
The income did not change. Only the price investors were willing to pay for it did.
This sensitivity is why cap rate assumptions deserve scrutiny. Overly optimistic exit caps can make weak deals appear attractive. Conservative exit caps tend to reveal whether the operating performance actually stands on its own.
Cap Rates and Risk
Lower cap rates tend to be associated with assets that have stable income, strong tenant demand, limited operational variability, and deep buyer pools. Higher cap rates tend to compensate for uncertainty: tenant turnover, location risk, regulatory exposure, capital intensity, or management complexity.
Assets that trade at very low cap rates have less margin for error. When income falters or financing tightens, values can adjust quickly. Higher-cap assets often start with more income cushion but carry other forms of risk that justify the higher yield.
Common Mistakes With Cap Rates
One common error is comparing cap rates across markets or asset types without adjusting for differences in growth, risk, and liquidity. A 6 percent cap in one market is not inherently better or worse than an 8 percent cap in another.
Another mistake is assuming that a lower cap rate implies a safer investment. Lower cap rates reduce current income relative to price, which increases reliance on future performance. Safety depends on durability, not just pricing.
Finally, cap rates are sometimes used mechanically without understanding what drives them. Treating them as static inputs rather than market signals leads to false precision.
Conclusion
Cap rates are a pricing tool. They translate income into value based on how the market views risk and opportunity at a given moment. Used carefully, they help investors understand how aggressively income is being valued and where assumptions are doing the heavy lifting. Used carelessly, they disguise risk behind a single number.
Understanding cap rates means understanding what the market is being asked to believe about the income behind them.