What is a cap rate — and what moves it?

Q: Is a higher cap rate better?

Not necessarily. A higher cap rate usually signals higher return but also higher risk — an older asset, a weaker market, or shorter leases. Lower cap rates typically reflect safer, higher-quality, more competitively bid properties.

Q: Does a cap rate include the mortgage?

No. A cap rate is unleveraged — it uses net operating income before any debt service. It measures the property's return independent of how you finance it.

Q: How do interest rates affect cap rates?

They tend to move together. When interest rates rise, borrowing costs more and buyers demand higher returns, which pushes cap rates up and values down. When rates fall, cap rates often compress.

Last updated: August 2026

The short answer

A capitalization rate — “cap rate” — is a commercial property’s annual net operating income divided by its price or value, written as a percentage. It measures the unleveraged return a property produces at today’s price. Cap rates move with a property’s income, its risk, and prevailing interest rates.

The formula

A cap rate connects three numbers — income, value, and return. Fix any two and you can solve for the third, which is why it’s the first tool most commercial investors reach for.

Cap rate

Cap Rate = Net Operating Income ÷ Property Value

Rearranged: Value = NOI ÷ Cap Rate · NOI = Value × Cap Rate

Net operating income (NOI) is the property’s income after operating expenses — but before mortgage payments, income taxes, and capital costs. That’s the key: a cap rate is unleveraged. It describes the property itself, independent of how any particular buyer finances it. (For the full breakdown, see what NOI is and how to calculate it.)

A worked example

Say a small retail building produces $87,500 in net operating income a year and is priced at $1,250,000:

Example — 7% cap rate

Net operating income (annual)	$87,500
Price	$1,250,000
Cap rate ( $87,500 ÷ $1,250,000 )	7.0%

Flip it around and the same math values a deal: if a buyer wants a 7% return and the building throws off $87,500 in NOI, they can pay about $1.25M ( $87,500 ÷ 0.07 ). Push the required return to 8% and the value falls to roughly $1.09M — same income, higher required return, lower price. That inverse relationship is the whole game.

What actually moves a cap rate

Cap rates aren’t set by a formula alone — the market sets them, deal by deal. The main forces:

Income (NOI). Raise rents or cut expenses and, at the same price, the cap rate rises. It’s the numerator.
Price and demand. More buyers competing for a property bid the price up and compress the cap rate. Thin demand does the opposite.
Risk and asset quality. A stabilized, well-leased, modern building trades at a lower cap rate (a premium price); an older, vacant, or management-intensive asset trades higher.
Location and market. Prime, liquid markets command lower cap rates; secondary and tertiary markets carry higher ones to compensate for risk.
Interest rates. When borrowing gets more expensive, buyers demand higher returns — cap rates tend to rise and values soften. Falling rates tend to compress them.
Lease and tenant quality. Long leases with strong, creditworthy tenants lower perceived risk — and the cap rate with it.

What a cap rate is not

A cap rate is a clean snapshot, but it has limits. It’s unleveraged, so it doesn’t reflect your actual cash-on-cash return once financing is involved. It’s a point in time, so it doesn’t capture rent growth, appreciation, or future capital expenditures. And a low cap rate isn’t “bad” any more than a high one is “good” — each is pricing in risk. Use it alongside cash-on-cash return and a full underwriting, never on its own.

Common questions

Is a higher cap rate better?

Not necessarily. A higher cap rate usually means higher return and higher risk — an older asset, a weaker market, or shorter leases. Lower cap rates typically reflect safer, higher-quality, more competitively bid properties.

Does a cap rate include the mortgage?

No. A cap rate is unleveraged — it uses NOI before any debt service. It measures the property’s return independent of how you finance it.

What’s a “good” cap rate?

There’s no universal number — it depends on the asset class, the market, and the moment. Multifamily in a prime market might trade far tighter than suburban retail. Judge a cap rate against comparable properties, not an absolute benchmark.

How do interest rates affect cap rates?

They tend to move together. When rates rise, borrowing costs more and buyers demand higher returns, pushing cap rates up and values down. When rates fall, cap rates often compress.