What Is a Cap Rate in Commercial Real Estate?
A cap rate, short for capitalization rate, is one of the most important metrics in commercial real estate. It measures the rate of return an investor can expect from a property based on its net operating income (NOI) and purchase price — without considering financing.
In other words, the cap rate helps you quickly gauge whether a property’s income potential aligns with its asking price and level of risk.
How to Calculate a Cap Rate
The formula is simple:
Cap Rate = Net Operating Income (NO I) ÷ Purchase Price
Example:
If a retail building produces $200,000 in NOI and sells for $3 million, the cap rate is:
$200,000 ÷ $3,000,000 = 6.67 %.
This means that, assuming no debt, the investor earns about 6.67 % annually on their capital.
Why Cap Rates Matter to Investors
Cap rates provide a quick, apples-to-apples way to compare properties of similar type and risk. They reflect three core elements:
- Risk level — Higher-quality, stable assets trade at lower cap rates; riskier assets require higher ones.
- Market conditions — Interest-rate trends and investor demand push cap rates up or down.
- Property performance — A property’s income stability, lease terms, and tenant credit directly affect its cap rate.
In essence, the cap rate represents the market’s perception of risk versus reward.
How to Interpret High vs. Low Cap Rates
Many new investors assume that a high cap rate equals a great deal — but it’s not that simple.
Low Cap Rate (4 % – 5 %)
- Typically means lower risk and high-quality assets (prime locations, national tenants, long leases).
- Reflects strong demand and limited supply.
- Offers lower returns but greater stability.
- Common in Class A retail, medical, and industrial properties in core markets like Los Angeles or the South Bay.
High Cap Rate (7 % – 9 % +)
- Suggests higher risk — short leases, local tenants, older buildings, or weaker markets.
- May produce stronger cash flow, but with greater volatility or management burden.
- Often found in tertiary markets or properties with value-add potential.
Key takeaway: A high cap rate doesn’t always mean “good deal.” It usually means more uncertainty, and the return comes with added risk.
When a High Cap Rate Might Be Worth It
A high-cap-rate property can make sense if:
- You understand the risk factors (short leases, deferred maintenance, etc.).
- You have a clear value-add or repositioning strategy to raise rents or improve occupancy.
- You’re comfortable managing more active operations for higher yield.
Experienced investors look beyond the number to the story behind the cap rate — tenant stability, lease structure, and local market fundamentals all matter more than the percentage alone.
How to Use Cap Rates to Evaluate a Deal
- Compare to Market Averages:
Look at cap rate ranges for similar property types in the same submarket.
(For example, in the South Bay, Class A industrial trades around 5 %–5.5 %, while older multi-tenant retail may trade closer to 6.5 %–7 %.) - Verify the NOI:
Make sure income and expenses are accurate and normalized — inflated NOI can distort the cap rate. - Factor in Future Upside:
A property with below-market rents may have a lower current cap rate but higher long-term value. - Consider Financing Impact:
Cap rates measure unleveraged returns; your actual return depends on your debt terms and cash-on-cash yield.
Why Cap Rates Change Over Time
Cap rates fluctuate with:
- Interest rate shifts (higher rates usually push cap rates up).
- Investor sentiment (flight to safety lowers cap rates on stable assets).
- Supply and demand for specific property types or regions.
In tight credit environments, even great properties can see rising cap rates because investors demand more yield to offset borrowing costs.
Final Thoughts
Understanding cap rates in commercial real estate is crucial for making smart, data-driven investment decisions. But remember: cap rates are just one piece of the puzzle. They measure current income, not future performance.
A low cap rate may represent stability and strong appreciation potential; a high one might signal opportunity — or hidden risk. The key is to understand why the cap rate is what it is.
At Ybarra Commercial Group, we help investors evaluate properties using cap rates, cash-on-cash returns, and full financial modeling to uncover true value and risk.
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