Cap Rate (Capitalization Rate)
The ratio between a property's Net Operating Income (NOI) and its purchase price, expressed as a percentage. Used to evaluate and compare investment property values.
The Capitalization Rate, commonly called "Cap Rate," is the fundamental metric for valuing commercial real estate investments. It represents the expected rate of return on an investment property based on its income-producing potential. **The Cap Rate Formula:** Cap Rate = (Net Operating Income ÷ Purchase Price) × 100 **Example Calculation:** If a property generates $150,000 in annual NOI and is priced at $2,500,000: Cap Rate = ($150,000 ÷ $2,500,000) × 100 = 6.0% **Understanding Cap Rate Dynamics:** **Lower Cap Rates (4% - 5.5%)** indicate: - Lower perceived risk - Investment-grade tenant credit - Longer remaining lease terms - Prime locations - Higher property values relative to income **Higher Cap Rates (6.5% - 8%+)** indicate: - Higher perceived risk - Non-investment-grade tenants - Shorter remaining lease terms - Secondary/tertiary markets - Value-add or turnaround opportunities **Cap Rate vs. Other Metrics:** Cap Rate provides a snapshot valuation but doesn't account for financing costs, appreciation potential, or tax benefits. Sophisticated investors also consider Cash-on-Cash Return, IRR, and equity multiple. **Market Benchmarks (Current NNN Market):** - Walgreens/CVS: 5.0% - 5.75% - Dollar General: 5.75% - 6.50% - QSR (McDonald's, Starbucks): 4.5% - 5.5% - Auto Parts (O'Reilly, AutoZone): 5.5% - 6.25% **Using Cap Rate for Valuation:** Property Value = NOI ÷ Cap Rate If you want to buy at a 6% cap with $120,000 NOI: Value = $120,000 ÷ 0.06 = $2,000,000
Frequently asked questions
What is a good cap rate for NNN properties?
A 'good' cap rate depends on your investment goals and risk tolerance. Investment-grade NNN properties typically trade between 5.0% - 6.5%. Lower cap rates (under 5.5%) indicate premium, lower-risk assets. Higher cap rates (above 6.5%) may indicate value-add opportunities or higher risk profiles.
How do you calculate property value from cap rate?
Property Value = Net Operating Income ÷ Cap Rate. For example, a property with $100,000 NOI purchased at a 6% cap rate is valued at $1,666,667 ($100,000 ÷ 0.06).
Why do cap rates vary by tenant?
Cap rates reflect perceived risk. Investment-grade tenants (Walgreens, McDonald's) command lower cap rates because their financial strength reduces default risk. Non-investment-grade tenants trade at higher cap rates to compensate investors for increased risk.
Related: noi, absolute-nnn-lease, investment-grade-tenant, cap-rate-compression, cash-on-cash-return