If you're beginning to look at commercial real estate investments, one of the first terms you'll encounter is capitalization rate, usually shortened to cap rate.
A cap rate is a simple way of comparing a property's annual income with its value.
The basic formula is:
Cap Rate = Net Operating Income ÷ Property Value
Suppose a commercial property produces $100,000 in annual net operating income and is valued at $1,250,000.
$100,000 ÷ $1,250,000 = 8%
The property's cap rate would therefore be 8%.
What is Net Operating Income?
Net operating income, or NOI, is the income generated by a property after normal operating expenses are deducted, but before items such as mortgage payments and income taxes.
That distinction matters because a cap rate is intended primarily to evaluate the property itself, rather than an individual investor's financing structure.
Is a higher cap rate better?
Not necessarily.
A higher cap rate can indicate greater potential income relative to the purchase price, but it can also reflect greater perceived risk.
A lower cap rate may indicate investors are willing to accept a lower return because they consider the property, tenant, location or market less risky.
That's why comparing cap rates without understanding the underlying properties can be misleading.
Why cap rates matter
For investors, brokers and property owners, cap rates provide a useful starting point for comparing income-producing real estate.
But they are only one part of the analysis.
Lease terms, tenant credit, vacancy, future capital expenses, location, rent growth and the condition of the property can all dramatically change the attractiveness of an investment.
NRD CRE Explained will break down concepts like NOI, triple-net leases, 1031 exchanges, zoning and commercial property valuation without assuming the reader already speaks commercial real estate.