Glossary · Underwriting metric
Cap Rate (Capitalization Rate)
Also called: initial yield
The capitalization rate (cap rate) is a property's net operating income divided by its value or sale price; it expresses price as an income yield and is used to value income-producing real estate and compare pricing across assets.
If a building earns $1 million a year from operations and sells for $20 million, its cap rate is 5%. The cap rate is the income yield a buyer accepts on the price paid, before any borrowing. A lower cap rate means buyers pay more for each dollar of income, usually because they see the income as safer or expect it to grow.
Formulas
Cap rate and direct capitalisation
- NOI
- net operating income for the stated period, usually twelve months; the basis (in-place, trailing, forward or stabilised) must be stated
- V
- value or sale price of the property; state whether before or after transaction costs
- c
- capitalization rate, as a decimal or percentage
The glossary of the National Council of Real Estate Investment Fiduciaries (NCREIF) defines the cap rate as NOI divided by the sales price or value. INREV's net initial yield uses passing rent or NOI over gross property value including notional purchaser's costs, so it is lower than a cap rate on the net price for the same deal. Going-in cap rates may use trailing or forward NOI; say which.
Link to the discount rate (constant growth)
- NOI1
- NOI expected over the next twelve months
- r
- investors' required total return (discount rate) on the unlevered property
- g
- constant expected growth rate of NOI, net of the capital spending needed to sustain it
A simplification of a discounted cash flow. It shows why cap rates move with interest rates and risk premia (r) and with growth expectations (g). Real properties need capital spending and do not grow at a constant rate.
Variants and conventions
- Going-in (initial) cap rate: NOI at purchase over price. Some use trailing twelve-month NOI, others the next twelve months.
- Exit, terminal or residual cap rate: the rate applied to projected NOI, usually the year after sale, to estimate the sale price at the end of a hold or the terminal value in a discounted cash flow.
- Stabilised cap rate: applied to NOI after lease-up or repositioning.
- Transaction vs appraisal cap rates: observed in sales or used by valuers; surveys of market cap rates differ in method and coverage.
- Net initial yield: the European measure, defined by the European Association for Investors in Non-Listed Real Estate Vehicles (INREV), that adds notional purchaser's costs to the price.
Two cap rates are comparable only if their NOI and value bases match.
What drives cap rates
Cap rates reflect what buyers require and expect: the level of interest rates and the risk premium over them, expected NOI growth, lease length and tenant credit, the capital spending the building will need, location and liquidity. When rates or risk premia rise, cap rates tend to rise (expansion) and values fall; when they fall, cap rates compress and values rise. Cap rates can also move when growth expectations change with no change in rates.
A cap rate is not a return
The cap rate is a one-year income yield on value. It equals the unlevered total return only if NOI is flat forever, no capital spending is needed and the cap rate does not change. The constant-growth relation above shows the gap: total return is approximately the cap rate plus NOI growth, less capital spending. A low cap rate does not mean an asset is overpriced if its income is secure and growing, and a high cap rate may only compensate for vacancy risk or a short remaining lease. For the investor's return, use IRR on projected cash flows; for income on leveraged equity, use cash-on-cash return.
How cap rates are used
Valuers and buyers use direct capitalisation to value stabilised income-producing property, and an exit cap rate to set terminal value in a discounted cash flow. Lenders read the cap rate together with loan-to-value (LTV) and debt yield: debt yield equals cap rate divided by LTV on the same NOI and value. In performance attribution, a change in the cap rate between purchase and valuation measures how much of the return came from market repricing rather than from NOI growth. Developers compare yield on cost with the market cap rate to see whether a project creates value.
Worked examples
Illustrative going-in cap rate
A building with NOI of $1.2m is bought for $20.0m. The going-in cap rate is 6.0%.
Sensitivity of value to the cap rate
If buyers demand 6.5% instead of 6.0% for the same $1.2m of NOI, value falls to $18.46m, about 7.7% lower. A half-point move in the cap rate does to value what a 7.7% fall in NOI would do.
Exit cap rate expansion
An investor pays $20.0m for NOI of $1.0m, a 5.0% cap rate. Over the hold, NOI grows 10% to $1.1m, but the market cap rate rises to 6.0%. The exit value is $18.33m, below the purchase price despite higher income. Underwriters therefore test exit cap rates at and above the going-in rate.
Net initial yield vs cap rate
On the same $1.2m of NOI and a $20.0m net price, assume purchaser's costs of 5% of the price (the actual rate depends on the country and the transaction). INREV's net initial yield divides NOI by the gross value including those costs, $21.0m: 5.71%, against a 6.0% cap rate on the net price.
Cap rate as discount rate minus growth
Current NOI is $1.0m and is expected to grow 2% a year indefinitely, so next year's NOI is $1.02m. Investors require an 8% unlevered return. Value is $1.02m / (8% − 2%) = $17.0m. The forward cap rate is 6.0%, equal to 8% − 2%; the trailing cap rate on the current $1.0m is 5.9%. Higher required returns or lower growth push the cap rate up.
Examples are illustrative; figures are not market data.
Not the same as
- Yield on Cost: Yield on cost divides stabilised NOI by total project cost; the cap rate divides NOI by market value or price.
- Debt Yield: Debt yield divides NOI by the loan amount, not by value.
- Discounted Cash Flow (DCF): A discounted cash flow values a property at a required total return, the discount rate, on all future cash flows; under constant growth the cap rate equals that discount rate minus growth.
- Internal Rate of Return (IRR): IRR is the annualised return over the whole hold, including growth and sale proceeds; the cap rate is a single-year income yield.
Common mistakes
- Comparing cap rates computed on different NOI bases, such as trailing versus forward, or before versus after a capital reserve.
- Treating the cap rate as the expected return on the investment.
- Assuming a low cap rate means the asset is expensive, without considering income security and growth.
- Applying a market cap rate to a vacant or transitional property's in-place NOI.
- Underwriting an exit cap rate below the going-in rate without a specific reason.
Edge cases
- For a property with very low or negative NOI the cap rate is meaningless; value it on stabilised projections or replacement cost.
- Long net leases to strong tenants trade more like bonds; their cap rates track interest rates and tenant credit more than property markets.
- Hotel cap rates are commonly quoted on NOI after a reserve for furniture and equipment; check before comparing with other sectors.
Questions
What is a good cap rate?
There is no universal good level. A cap rate is a price: it should be compared with cap rates for similar buildings, leases and locations at the same time, on the same NOI basis.
Is a higher cap rate better for the buyer?
It means more income per dollar paid today, but usually because the income is riskier or expected to grow less. Whether it is better depends on that risk and growth.
What is cap rate compression?
A fall in market cap rates, which raises values for the same NOI. Expansion is the reverse.
External standards
| Standard | Relation | Note |
|---|---|---|
| Global Definitions Database (D0972 Capitalization (Cap) Rate (NCREIF)) | equivalent | |
| Global Definitions Database (D0176 Net Initial Yield (INREV)) | related | Denominator includes notional acquisition costs. |
Sources
- Global Definitions Database (GDD). INREV (hosted); entries attributed to INREV, NCREIF or NCREIF PREA, Per-entry versions and dates (entries opened 2026-10-01). Status: current (checked 2026-10-01). D0972 Capitalization (Cap) Rate; D0176 Net Initial Yield — supports: Cap rate definition; net initial yield convention
Related terms
5 termsReferenced by
4 termsConcept record
- Concept ID
- ALTSS-RE-012
- Classification
- Underwriting metric · Valuation
- Topics
- Real estate
- Version
- 2.0.0
- Last reviewed
- Structured data
- JSON