August Blog
What Is a Cap Rate—and What Does It Really Tell You?
If you invest in commercial real estate, cap rate is one of the first numbers you need to understand. It's also one of the easiest numbers to misuse.
A cap rate gives you a quick way to compare a property's income to its price. I look at it on nearly every investment property that crosses my desk—but I never use it alone to decide whether a deal is good or bad.
Here's what a cap rate tells you, what it doesn't, and how investors should use it.
How Do You Calculate a Cap Rate?
The formula is straightforward:
Cap Rate = Net Operating Income (NOI) ÷ Purchase Price
If a property generates $100,000 in annual NOI and is priced at $1.25 million, the cap rate is 8%.
NOI is the income remaining after operating expenses but before debt service and income taxes. In simple terms, the cap rate shows the property's first-year return based on its current income, assuming you purchased it without financing.
The math is easy. Understanding what that number means is where the real work begins.
Is a Higher Cap Rate Better?
Not necessarily.
Cap rates generally move inversely to property values. A higher cap rate means you're paying less for each dollar of income. A lower cap rate means you're paying more.
But there's usually a reason.
A property trading at a 5% cap rate may have a strong national tenant, a long-term lease, and an excellent location. Investors perceive less risk and are willing to accept a lower return.
A property at a 9% cap rate may have a weaker location, short-term leases, vacancy issues, an uncertain tenant, or significant capital needs.
Higher return often comes with higher risk. That's why comparing cap rates without understanding the properties behind them can be misleading.
What Is a Good Cap Rate?
There isn't one universal "good" cap rate.
A good cap rate is one that appropriately compensates you for the risk you're taking.
For example, a 5.5% cap on a single-tenant property occupied by a national credit tenant with a long-term lease in a strong Metro Atlanta corridor could be very attractive.
Meanwhile, a 9% cap on a half-empty shopping center with leases expiring in two years could be a much riskier investment.
The number only makes sense when you understand the story behind it.
What a Cap Rate Doesn't Tell You
This is where investors can get into trouble. A cap rate is simply a snapshot of income versus price. It doesn't tell you everything you need to know about the investment.
It doesn't account for financing, which can dramatically change your actual cash-on-cash return.
It doesn't capture future growth, such as scheduled rent increases, below-market leases, or opportunities to increase occupancy.
It also doesn't account for major capital expenses. A new roof, HVAC system, or parking lot can quickly change the economics of an otherwise attractive deal.
And most importantly, a cap rate is only as reliable as the income used to calculate it.
In-Place vs. Pro-Forma Cap Rate
This distinction is critical.
An in-place cap rate is based on the income the property is actually producing today.
A pro-forma cap rate is based on what the property could produce after assumptions such as higher occupancy, increased rents, renovations, or other improvements.
Sellers naturally want buyers focused on the property's potential. Investors need to understand what they're actually buying today.
I always start with the in-place income. Then we can determine whether the seller's projected upside is realistic—and what it will cost to achieve it.
How I Use Cap Rates
For me, cap rate is a sanity check, not a final decision.
In about 60 seconds, it can tell me whether an asking price is reasonably aligned with the income a property produces and how it compares with similar assets in that submarket.
If the cap rate looks dramatically different from comparable properties, that's not necessarily a reason to walk away. It's a reason to ask why.
That's when the real underwriting begins.
Used correctly, cap rate is one of the most useful tools in commercial real estate. Used as the entire investment analysis, it can also be one of the most misleading.
If you're evaluating a commercial investment in Metro Atlanta and want help determining whether the numbers—and the story behind them—make sense, let's talk.
Mark Ellsworth
Principal Broker | Southern Equity Commercial
Serving Metro Atlanta and the Southeast
mark.ellsworth@kw.com | 404-449-6275