By Steven Llorens
(From a CRE Professional Who’s Seen It All)
Early in my Commercial Real Estate (CRE) career, I remember sitting across the table from a seasoned investor. I was fresh, eager, and rattling off property details.
He leaned in, smiled politely, and asked:
“What’s the cap rate?”
I stumbled through a basic definition, but it was clear: I didn’t fully grasp the power behind that simple term.
Fast forward 15 years: cap rates are now second nature to me and understanding them has made the difference between deals that build wealth and deals that bleed money.
Today, I want to guide you through what I wish someone had taught me early on, not just what cap rates are, but how they impact everything in CRE investing.
What Is a Cap Rate? (And Why It’s So Important)
Let’s start simple:
A Capitalization Rate (or cap rate) is the ratio of a property’s Net Operating Income (NOI) to its purchase price (or value).
Here’s the basic formula:
Cap Rate= NOI/Purchase Price
Example: If a property generates $100,000 a year in NOI and you buy it for $1,250,000:
Cap Rate= 100,000/1,250,000
Cap Rate = 8%
That 8% tells you about the annual return on investment, assuming you paid all cash and without factoring in financing.
Why does it matter so much?
Because it’s the fastest way to:
- Measure a property’s relative value.
- Compare different investment opportunities.
- Understand the risk and reward profile of an asset.
The Truth About Cap Rates: Higher Isn’t Always Better
Early on, I thought a higher cap rate was always the better choice.
8% cap? Better than a 5% cap, right?
Wrong.
Here’s the truth: Higher cap rates usually mean higher risk.
Let’s break it down:
- Low cap rates (3–6%): Usually in core markets like New York, San Francisco, or top-tier assets with strong tenants. They’re “safer” but you’re paying a premium for stability.
- High cap rates (7–10%+): Common in secondary/tertiary markets or properties with challenges think lease expirations, aging buildings, or shaky tenants.
Data Point:
According to CBRE’s 2024 Cap Rate Survey, prime office buildings in major cities average cap rates around 5.0%, while suburban retail centers often range from 7.0% to 8.5%.
Pro Tip: A high cap rate can look juicy but make sure you understand why it’s high. Sometimes, it’s because you’re inheriting problems that cash flow alone can’t fix.
What Factors Drive Cap Rates Up or Down?
Over the years, I’ve learned that cap rates are like the heartbeat of the CRE market.They constantly shift based on:
1. Interest Rates
One of the biggest drivers.
When interest rates rise, cap rates tend to rise too. Investors demand higher returns to compensate for more expensive borrowing.
Example:
In 2022-2023, as the Fed raised rates aggressively, we saw cap rates inch upward across almost every sector.
2. Property Type and Asset Class
Different asset classes carry different risk profiles:
- Multifamily properties usually have lower cap rates (less vacancy risk).
- Hotels and retail centers tend to have higher cap rates (more volatile income streams).
Let’s look at the Statistics according to Marcus & Millichap, 2024 average cap rates by sector are:
- Multifamily: 5.3%
- Industrial: 5.7%
- Retail: 6.4%
- Office: 7.1%
3. Location, Location, Location
Trophy cities (NYC, LA, Miami) command lower cap rates.
Secondary markets (Columbus, Boise, Kansas City) offer higher caps to attract investors.
How Cap Rates Affect Property Values
Here’s something critical many newbies miss:
Small changes in cap rate = Big changes in value.
Let’s say you have a property with $100,000 NOI:
- At a 5% cap rate → Property value = $2,000,000
- At a 6% cap rate → Property value = $1,666,666
- At an 8% cap rate → Property value = $1,250,000
A 1% change in cap rate can swing value by hundreds of thousands of dollars.
Pro Tip: Always stress-test your deal by running scenarios:
“If cap rates move by 0.5% or 1%, what happens to my value?”
Smart investors build a margin of safety.
Cap Rates and Exit Strategy
When I underwrite deals, I’m always thinking:
How will cap rates look when I sell?
If you buy at a 5.5% cap rate and market conditions worsen (rising interest rates, economic slowdown), you might have to sell at a 6% or 6.5% cap rate impacting your resale price.
Example:
If you bought for $1.8M at a 5.5% cap and NOI stays flat at $99,000:
- Selling at 6.5% = Value drops to $1,523,000.
That’s a $277,000 haircut even if the property’s performance didn’t change!
Pro Tip: When modeling your pro forma, build conservative exit assumptions. You hope for cap rate compression but plan for cap rate expansion.
How I Personally Use Cap Rates When Evaluating Deals
Here’s my quick checklist that you can follow as well:
- I compare going-in cap rate to market comps to see if I’m buying right.
- I analyze the stabilized cap rate post-renovation or leasing up.
- I model a worst-case exit cap 50–100 basis points higher than my entry cap.
- I match cap rate expectations to my investment goals (stability vs. upside).
Pro Tip: In volatile markets (like 2024), I put even more weight on cap rate movement. With uncertainty everywhere, your margin of error matters more than ever.
Final Thoughts
Understanding cap rates isn’t just a technical skill.
It’s a lens a way to see opportunity, risk, and value clearly in the complex world of CRE.
Mastering cap rates means you:
- Make smarter buys.
- Manage risk like a pro.
- Plans exit with confidence.
- Sleep better at night, knowing you’re not gambling you’re investing strategically.
Trust me:
It’s not just about chasing the highest cap rate. It’s about chasing the smartest return for the right risk.
Learn cap rates. Live them. Respect them.
And you’ll be amazed how many doors and deals they open for you.
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