Capitalization Rate (Cap Rate)

The capitalization rate, or cap rate, is a property's net operating income divided by its value. It expresses the property's yearly income as a percentage of what the property is worth. Investors use it to compare properties and price deals. Appraisers and lenders use it to estimate value.

The formula in words: cap rate equals net operating income (NOI) divided by property value.

Worked example. A small warehouse produces NOI of $100,000 a year and sells for $1,250,000. Cap rate = $100,000 ÷ $1,250,000 = 8%.

The same formula works in reverse to estimate value. Appraisers call this direct capitalization: value equals NOI divided by the cap rate. If similar warehouses nearby trade at an 8% cap rate, a building with $100,000 of NOI is worth about $100,000 ÷ 8% = $1,250,000.

Cap rates reflect risk and market conditions. Riskier properties, weaker locations and shorter leases tend to have higher cap rates. Over time, cap rates also tend to move with interest rates.

Why it matters for lenders

Small changes in the cap rate make big changes in value. With the same $100,000 of NOI, a 7% cap rate gives a value of about $1,430,000, while a 9% cap rate gives about $1,110,000. Two points of cap rate move the value by more than $300,000.

Because loan-to-value (LTV) depends on value, a lender's collateral cushion depends on the cap rate the appraiser chose. A loan that looks safe at a low cap rate can be too large if cap rates rise. US bank examiners expect lenders to stress collateral values and cap rates when they test individual loans. Some lenders also use debt yield, which leaves the cap rate out entirely.

For borrowers, cap rates are a market signal. Rising cap rates usually mean falling prices, which can make it harder to refinance when a loan matures.

How it works in practice

A lender reviews an appraisal for a refinance on a medical office building. The appraiser chose a cap rate based on recent sales of similar buildings. The underwriter checks those sales and notices most closed more than a year ago, when rates were lower. She asks the appraiser to explain why the cap rate still fits. She also runs her own test at a cap rate one point higher.

At the higher cap rate, the value drops and the LTV goes past the policy limit. She recommends a smaller loan.

The cap rate should be stored as its own data point on the loan, next to NOI and value, not buried in a PDF. Then the lender can recheck values across its whole portfolio when the market shifts.