Cap rate, also known as yield, is one of the key factors when measuring cash flow and profitability with commercial real estate. If something is yielding a great cap rate or cash-on-cash return, chances are it might be a smart investment play. For investors with multiple rental spaces, including those with vast portfolios with enough units being rented out via Airbnb and VRBO to be considered commercial real estate, and standard long-term rental properties, the cap rate helps determine profitability and whether a deal is worth pursuing. But how can you use cap rate to win in commercial real estate? Let’s break down how to use cap rate for commercial real estate below.
What is cap rate in commercial real estate?
Cap rate, or capitalization rate, represents the expected rate of return on a commercial real estate investment. It is expressed as a percentage and serves as a quick indicator of a property’s potential profitability. By comparing a property’s net operating income (NOI) to its market value or purchase price, the cap rate helps investors determine how much income they can expect to generate relative to their investment.
A higher cap rate often suggests greater risk but potentially higher returns, while a lower cap rate indicates a more stable, lower-risk investment with steady cash flow. However, cap rates vary significantly depending on property type, location, market conditions, and economic trends, making it important to refrain from using them as a catch-all metric and instead consider them alongside other valuation metrics.
Where:
Net Operating Income (NOI) = Total rental income – operating expenses (excluding mortgage payments).
Purchase Price = The total cost of acquiring the property.
For example, a property with a NOI of $100,000 and a purchase price of $1,500,000 has a cap rate of:
How cap rate works
So, how does cap rate work? Cap rate helps investors assess the potential return on a property by answering key questions such as how much income they can expect relative to the purchase price, how the property compares to others in terms of risk and profitability, and whether it represents a stable, low-risk investment or a high-risk, high-reward opportunity. By analyzing cap rates, investors can quickly gauge the financial viability of a property and make informed decisions about their real estate investments.
What is considered a good cap rate?
A “good” cap rate is not a fixed number but depends on a few different factors. This includes things like market conditions, location, and property type. In general, lower cap rates (4%–6%) indicate lower-risk, stable investments in high-demand areas, while higher cap rates (7%–10%) suggest higher-risk properties that may offer greater returns but come with a bit more risk.
Key variables affecting cap rates:
- Property type: Multifamily properties tend to have lower cap rates due to strong rental demand, while industrial and retail properties often have higher cap rates due to market fluctuations.
- Location: Properties in primary markets (New York, Los Angeles) typically have lower cap rates, whereas those in secondary and tertiary markets (Phoenix, Nashville) have higher cap rates.
- Market conditions: Interest rates, economic growth, and supply-demand balance impact cap rates, with higher rates usually correlating with riskier economic conditions.
Cap rate in action: Real-world examples using real properties
To understand how cap rates work in action, we can examine real-life examples across different property types and markets. While the cap rate is a useful metric, its meaning changes based on location, property demand, market conditions, and risk level. A low cap rate can indicate a prime, low-risk investment, while a high cap rate might signal greater potential returns but with added swings and volatility.
Below, we explore two contrasting cases: a good cap rate investment in a growing multifamily market and a high-risk cap rate investment in a struggling retail sector.
Example 1: A strong cap rate: Multifamily apartment in Austin, TX
Multifamily properties are often considered stable investments because demand for rental housing remains high in growing metropolitan areas. Austin, TX, has experienced rapid population growth, a thriving job market, and strong rental demand, making it an attractive location for investors.
In this example, an investor purchases a Class B multifamily apartment in a prime Austin neighborhood. The cap rate is 6.0%, which is competitive for the area and indicates a balance between strong cash flow and long-term appreciation potential. The stable tenant base, high occupancy rate, and potential for rent increases make this a pretty solid investment choice with moderate risk and both decent and reliable returns.
Key Property Details
| Property Feature | Details |
|---|---|
| Property Type | Class B Multifamily Apartment |
| Location | Austin, TX (High-growth market) |
| Purchase Price | $5,000,000 |
| Net Operating Income (NOI) | $300,000 |
| Cap Rate | 6.0% |
| Risk Level | Moderate |
| Market Conditions | Strong rental demand, rising property values |
| Investment Potential | Stable income, long-term appreciation |
Example 2: A risky cap rate: Retail space in downtrodden Detroit
Retail properties can offer high returns, but they also come with greater risks due to shifting consumer behavior, economic downturns, and location-based challenges. In cities with high commercial vacancy rates, retail spaces may struggle with tenant turnover, rent reductions, and declining property values.
In this example, an investor purchases a standalone retail building in Detroit, MI, a market that has seen economic instability and fluctuating demand for commercial space. Detroit was all over the news years back as a bankrupt and dying city, but since then, billions have been poured into the city, including from the owner of the Cleveland Cavaliers, Dan Gilbert. The property has a cap rate of 7.5%, which may seem attractive at first. However, the higher risk level associated with tenant uncertainty, potential vacancies, and market volatility makes this investment less stable. Without a long-term, reliable tenant, the property could struggle to generate consistent income.
Key Property Details
| Property Feature | Details |
|---|---|
| Property Type | Standalone Retail Building |
| Location | Detroit, MI (High-vacancy market) |
| Purchase Price | $1,200,000 |
| Net Operating Income (NOI) | $90,000 |
| Cap Rate | 7.5% |
| Risk Level | High |
| Market Conditions | Economic uncertainty, declining retail demand |
| Investment Potential | Volatile income, tenant turnover risk |
This comparison highlights why the cap rate should never be viewed in isolation. While a higher cap rate might suggest a better return, the underlying market risks and property conditions must be factored in before making an investment decision.
When people talk about commercial real estate, they often forget about senior living, which is a type of commercial real estate that is perpetually growing, because of the demographic changes in the US and worldwide. We spoke to Tanner Gish of LovingHomecareInc
What effects cap rate and ROI in senior care in terms of cost? The No. 1 unexpected overhead cost for senior homes is typically staffing and turnover-related expenses. The caregiving workforce often faces high turnover rates, which result in costs related to recruitment, training, and retention. Additionally, the shortage of qualified caregivers can drive up wages and benefit expenses, increasing operational costs. To hedge against this, senior homes should focus on staff retention strategies, such as offering competitive pay, ongoing training, career advancement opportunities, and creating a supportive work environment that helps reduce burnout and turnover
Comparing cap rates to other real estate valuation metrics
While the cap rate is useful, it’s not the only valuation tool investors should rely on when evaluating a property. It provides a snapshot of return based on current income, but it doesn’t account for financing, tax implications, or long-term cash flow projections. That’s why experienced investors often use cap rate alongside other metrics like cash-on-cash return, gross rent multiplier (GRM), and discounted cash flow (DCF). These tools help paint a more complete picture of an asset’s potential performance, especially in markets with fluctuating prices or varying levels of tenant risk. Using a combination of metrics leads to smarter, more balanced investment decisions.
Cap rate
Cap rate is one of the most commonly used metrics in real estate investing. It helps investors understand how much income a property generates in relation to its purchase price, offering a quick snapshot of potential return. However, it assumes a cash purchase and doesn’t account for debt or tax implications.
Formula: Net Operating Income (NOI) ÷ Property Price
Best for: Quick ROI evaluation on unleveraged investments
Limitations: Doesn’t factor in financing or long-term growth
Cash-on-cash return
This metric calculates the return on the actual cash an investor puts into a deal, making it especially useful for properties purchased with financing. It shows how effectively an investor’s capital is working year over year.
Formula: Annual Pre-Tax Cash Flow ÷ Total Cash Invested
Best for: Evaluating leveraged investments
Limitations: Ignores appreciation and future cash flow projections
Gross rent multiplier (GRM)
GRM is a quick filtering tool used in the early stages of property analysis. It compares the property’s price to its gross rental income, helping investors gauge how fast they could recover their investment based purely on rents.
Formula: Property Price ÷ Gross Rental Income
Best for: Comparing income potential across multiple properties
Limitations: Doesn’t consider expenses or operating costs
Discounted cash flow (DCF)
DCF is a more advanced method that estimates a property’s present value by forecasting its future cash flows and applying a discount rate. It’s especially helpful for long-term investors focused on appreciation, rent growth, and tax benefits.
Formula: Present Value of Future Cash Flows
Best for: Long-term investment planning and detailed financial modeling
Limitations: Requires complex assumptions and reliable forecasting
Cap rates in the US
Cap rates vary significantly across different U.S. markets, influenced by factors such as location, property type, and economic conditions. Below is a chart detailing average cap rates for various cities as of 2025:
Cap rates limitations
While cap rate is a valuable tool for evaluating real estate investments, it has limitations that investors should consider. It does not account for property appreciation, financing costs, or market fluctuations that can impact long-term profitability. Additionally, some common misconceptions about cap rate can lead to poor investment decisions if used in isolation. However, when combined with other valuation metrics, cap rate remains an effective way to compare properties and assess investment potential.
Below is a breakdown of key challenges, limitations, and benefits of using cap rate:
| Aspect | Limitation | Pro |
|---|---|---|
| Cap rate does not consider property appreciation | Property values can increase over time, but cap rate only reflects current income. | Cap rate still provides a quick, standardized way to compare properties. |
| Cap rate ignores financing or loan costs | Mortgage payments and financing terms are not included in cap rate calculations. | It helps investors assess raw income potential without debt complications. |
| Market fluctuations impact NOI over time | NOI can change due to economic shifts, tenant turnover, or unexpected expenses. | Investors can use historical trends to anticipate NOI changes. |
| Higher cap rate does not always mean a better deal | High cap rates can indicate higher risk or unstable market conditions. | Cap rate helps highlight potentially undervalued opportunities. |
| Cap rate is not the only metric that matters | Other factors like cash flow, tax benefits, and debt service coverage must be considered. | Cap rate is a great starting point when combined with other financial metrics. |
How cost segregation affects cap rates
Cost segregation is a powerful tax strategy that allows commercial real estate investors to accelerate depreciation deductions, reducing taxable income and increasing after-tax cash flow. While cap rate primarily measures a property’s return based on net operating income (NOI) and market value, cost segregation can enhance the financial attractiveness of a property by improving cash flow and tax efficiency.
By reclassifying certain building components into shorter depreciation schedules (such as 5, 7, or 15 years instead of the standard 27.5 or 39 years), investors can front-load their depreciation expenses, significantly lowering their taxable income in the early years of ownership. This reduces immediate tax liabilities and allows investors to reinvest those tax savings into additional properties, renovations, or debt reduction.
Bottom line: Cap rate is king in commercial but think ahead
Cap rate is a standard tool when it comes to real estate, as everyone needs to know how their real estate is performing via cash flow. In the commercial space, this can be particularly important when it comes to asset classes such as multifamily or retail. That being said, higher yields and cap rates generally come with higher risk, which is why cap rates in global first-tier cities like NY, Los Angeles, and London are low, yet considered safe. Always use other metrics, such as cap rate, but in the world of commercial real estate, if you are going to start with one data point, cap rate is not a bad choice.
FAQ
How does inflation impact cap rates?
Inflation can have a mixed effect on cap rates depending on how it influences interest rates and rental income. When inflation rises, property values may increase, but operating expenses and borrowing costs also go up, potentially compressing cap rates.
How do interest rates affect cap rates in commercial real estate?
Interest rates and cap rates are closely linked because higher borrowing costs typically lead to higher cap rates. When interest rates rise, the cost of financing a property increases, making investments less attractive unless sellers adjust pricing to maintain competitive returns. Lower interest rates, on the other hand, can compress cap rates as investors are willing to accept lower yields in exchange for cheaper financing and potential property appreciation.
