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Understanding Cap Rates: A Key Metric in Real Estate Investing
A cap rate is one of the most widely used metrics in commercial real estate, but for new investors, it may not be as intuitive as revenue or debt.
It offers a quick way to compare properties and gauge expected outcomes, but its ubiquity can be misleading. A cap rate isn't a definitive measure of value—it's just one tool in an investor's toolkit.
We believe understanding how cap rates work (and what they don't tell you) is a key step in getting started in the industry. Here's what every new investor should know.
Cap Rate 101: What is the Cap Rate Formula?
At its core, a cap rate (short for capitalization rate) is a quick way to assess how much income a property generates relative to its purchase price.
The formula is simple: Cap Rate = Net Operating Income (NOI) ÷ Purchase Price
For example, if a property generates $1 million in NOI and costs $10 million to acquire, its cap rate is 10%. A building with an 8% cap rate might seem like a better deal than one at 6%, if all else is equal.*
Cap rates are often used as a tool to measure an investment's relative risk profile.**
A higher cap rate means a property is priced lower relative to its income. These properties may be in less desirable locations, have shorter lease terms, or require improvements.
A lower cap rate can suggest properties may be in desirable locations, have strong tenant demand, or belong to asset classes with generally stable cash flow.*** Sellers can typically justify higher prices for these attributes, which brings cap rates down.
That said, these are generalizations. A cap rate isn't a definitive measure of a property's relative risk profile or quality—and various factors can drive it up or down, including interest rates.
In a low-rate environment, there is often increased competition for properties. This may drive up prices and compress cap rates. When rates rise, property values may decline, causing cap rates to expand. In this sense, cap rates can also help gauge market sentiment.
What are the Limitations of Cap Rates?
Cap rates can be a handy shorthand for comparing properties—especially when you're looking at deals that are as apples-to-apples as possible. But they leave out a lot. Knowing what cap rates don't tell you is just as important as knowing what they do.
Here are three gaps to keep in mind:
Leverage: Cap rates show an unlevered return—a property's income relative to its price, without factoring in debt. But, in our experience, most real estate sponsors don't pay all cash. Financing terms, like interest rates and loan structures, can change the math fast. A high cap rate might look great, but if borrowing costs are steep, it can change the entire outcome of the investment. On the flip side, low-cost financing can potentially make a lower-cap-rate property more attractive.
Future Cash Flows from Property Improvements: Cap rates are based on a property's current income, not what it could earn after renovations, lease adjustments, or operational improvements. Value-add strategies can change the property financials, but cap rates alone won't tell you that story.
Tenant Risk & Lease Structure: Cap rates don't tell you much about who's paying the rent or how secure that income is. A 15-year lease with a Fortune 500 company is a different story than month-to-month deals with local shops. Lease terms matter too. Triple-net leases (where tenants cover expenses) have lower risk of unforeseen expenses than gross leases (where you're on the hook). The cap rate can't show you that nuance—you need to dig in.
Learning the Language of Private Markets
Understanding terms like cap rates is a great first step toward learning the language of private market investing. These jargons get tossed around a lot—and while they might not click right away, a little reading is all it takes to get familiar.
Just keep in mind: some folks talk about cap rates like they're the whole story, but they're just one piece of the puzzle. We believe savvy investors consider plenty of other factors when evaluating an opportunity.
Head over to Crowd Street's Resource Center for more beginner-friendly content on private market investing. You'll find guides on accreditation, asset classes, and more.
1 https://www.jpmorgan.com/insights/real-estate/commercial-term-lending/cap-rates-explained
3 https://www.investopedia.com/terms/c/capitalizationrate.asp
*All examples are hypothetical and for illustrative purposes only.
**Investment opportunities available through Crowd Street are speculative and involve substantial risk. You should not invest unless you can sustain the risk of loss of capital, including the risk of total loss of capital. All investors should consider their individual factors in consultation with a professional advisor of their choosing when deciding if an investment is appropriate.
***'Cash-flow' or '˜Cash-flowing' when used by Crowd Street in this context refers to investments in which current revenues cover all expenses and typically provide leftover money at the end of the month. This does not mean, however, that this will provide a distribution directly to investors or that the investment will continue to perform in this manner. Distributions are never guaranteed and investing in commercial real estate entails substantive risk. You should not invest unless you can sustain the risk of loss of capital, including the risk of total loss of capital.
