Commercial real estate has its own vocabulary. IRR, GRM, NOI and CAP are all common terms bandied about or commonly seen in commercial listing remarks. Those aren’t government agencies; they’re shorthand for talking about money and math.
Residential agents do not need to know much commercial real estate vocabulary until an investor client asks, “What’s the CAP on that fourplex?” And then we should either figure it out or refer it out.
A CAP rate is one of the faster ways to tell if an income property is worth a second look. It won’t tell you if the deal is good. It tells you if the deal is worth the effort of finding out if it is good. All you need is a little information, property value and net operating income (NOI).
Net operating income divided by property value equals the capitalization, or CAP, rate. A fourplex generates $120,000 in annual NOI and costs $2 million. Divide one by the other, and you get a 6 percent CAP rate.
That means the property produces six cents of income for every dollar of value before debt service. The mortgage is not part of the calculation. Neither is the investor’s tax bill. CAP rate measures the property as if it were purchased with cash.
JPMorgan Chase describes CAP rates as a risk measurement that reflects investor expectations. Investopedia describes a CAP rate as an estimate of the return based on the income a property generates.
The AI ELI5YO version is simpler. Imagine the property is a magic money box. Whatever you paid for the box, the CAP rate tells you how much money comes out every year before you pay the bank or replace the roof.
A 6 percent CAP rate means every $100 you paid for the property produces $6 a year.
CAP rate is a screening tool, not an analysis. It gets you to the door. NOI, debt service, cash flow and capital expenditures will help you decide whether or not to recommend it to your people.
Question: Why do investors use CAP rates?
Answer: It is a scanning tool. Cap rate lets you compare properties the same way you compare interest rates on savings accounts: same language, different assets.
A cap rate — net operating income divided by purchase price — tells you about the return on a property assuming you paid cash. Higher cap means higher return and typically higher risk. Lower cap means lower return and often a more stable asset in a better location.
Think of it like a savings account. If one bank pays 4 percent and another pays 8 percent, you know the 8 percent account has more risk or worse terms. Same with real estate.
A 4 percent cap on a building near BART and an 8 percent cap on a building in a rural town are telling you different stories about risk, location and potential return.
The trick is never to buy based on cap rate alone; use it to screen out the obvious losers, then dig into the actual deal. Cap rate is one of the first filters, not the final answer.
Question: How do I calculate a CAP rate?
Answer: You need two things to calculate a cap rate: the property’s value or asking price and its net operating income.
Net operating income (NOI) is the annual income the property generates after paying operating expenses but before paying any debt service. Pay attention to me: NOI does not include mortgage payments.
Think of it as the property’s operating profit. You start with gross rental income — all rents, parking fees, laundry, storage, anything the property collects — then subtract the costs of running the place: property taxes, insurance, property management, maintenance and repairs, utilities if the landlord pays them and any other ongoing operating costs.
Capital expenditures like a new roof are not included. Financing costs like mortgage payments are also not included.
The formula: Cap Rate = NOI ÷ Property Value
Question: Is a higher CAP rate always better?
Answer: Not necessarily; a higher cap rate can indicate more risk. You need to compare it to the average cap rate for the same property type in the same market.
A 6 percent cap on a stabilized apartment in San Francisco tells you something completely different than a 6 percent cap on a rural strip center with one tenant on a short lease.
One of the best sources for these averages is the CBRE U.S. Cap Rate Survey. It covers more than 50 markets and multiple property types. Their survey shows where cap rates sit across multifamily, industrial, office and retail. It’s a good tool to use to help determine what’s average for your area.
Question: Can I use a CAP rate for a single-family rental?
Answer: You can use a cap rate for a single-family rental, and plenty of investors do. A property generating $100,000 in NOI with a $1 million price tag delivers a 10 percent cap rate. The math doesn’t change because the building has one unit instead of 50.
What changes is what a “good” cap rate looks like. In most markets, the ideal range for SFRs falls between 8 percent and 12 percent. In stronger markets, the range drops to 4 percent to 6 percent. Location matters.
That said, cap rate is just one piece of the puzzle. It ignores financing, so it won’t tell you your actual monthly cash flow after the mortgage. It is also less useful for fix-and-flip plays or vacant properties where NOI is projected rather than proven.
Each week in America Answers, Inman contributor America Foy answers questions from the industry at large and offers advice on how to handle the situation.
Have questions? Email America Foy
America Foy is a broker associate at The Grubb Co. Get connected on LinkedIn and Instagram.
