The Role of Cap Rates in Real Estate

Introduction

If you’re confused by cap rates, you’re not alone. It’s one of the first terms you’ll hear in real estate finance — and one of the most commonly misunderstood. The good news? Once you understand the basics, it becomes one of the easiest tools to use when evaluating a property.

Let’s walk through it step-by-step.

Cap Rate Definition (The Simple Version)

A cap rate (short for capitalization rate) is a simple way to measure how much income a property generates compared to what it costs. In plain terms, it answers the question:

If I bought this property in cash, what return would I earn each year from rental income?

The formula is straightforward:

Cap Rate = Net Operating Income (NOI) ÷ Purchase Price

• Net Operating Income (NOI) is the income a property earns after paying for things like taxes, insurance, and maintenance — but before any loan payments.

• Purchase Price is how much you’d pay to buy the property.

The result is a percentage — and that percentage tells you how “efficiently” the property is generating income.

Cap Rate Example: Step-by-Step

Let’s say you’re looking at a small office building:

• NOI = $80,000

• Purchase Price = $1,000,000

Now plug it into the formula:

Cap Rate = $80,000 ÷ $1,000,000 = 0.08, or 8%

That 8% is your return — if you bought the building in cash. So, for every $100 you invest, you’d earn $8 per year in net income from rent.

What the Cap Rate Doesn’t Include

Cap rate is a quick snapshot — but it leaves out a lot. It doesn’t include:

• Loan payments (debt service)

• Tax savings or depreciation

• Future rent increases or lease renewals

• Renovation costs or capital improvements

That’s why cap rate is best used as a starting point — not a final decision-maker. It gives you a rough sense of return and helps you compare deals quickly, especially when you don’t have a full model built yet.

When the Cap Rate Is Helpful

Cap rates come in handy when you want to:

• Compare two similar properties side-by-side

• Check if a price “makes sense” given the income

• Estimate value based on market cap rates

You’ll see cap rates everywhere — in listing flyers, offering memos, class assignments, and interviews. So it’s worth understanding how to use them with confidence.

Using the Cap Rate to Estimate Property Value

You can also flip the cap rate formula to estimate what a property might be worth.

The reverse formula is:

Value = NOI ÷ Cap Rate

Here’s an example: Let’s say a property earns $60,000 in NOI, and similar properties are trading at a 6% cap rate in the market.

Value = $60,000 ÷ 0.06 = $1,000,000

In other words, if investors in the area expect a 6% return, they’d be willing to pay around $1 million for that level of income.

This version of the formula is especially useful when working through class problems, underwriting assignments, or trying to reverse-engineer pricing.

Cap Rates Reflect Risk (Not Just Income)

Cap rates don’t just measure income — they also reflect risk. In general:

• Lower cap rate = lower risk

• Higher cap rate = higher risk

Think about it this way: Investors are willing to accept a lower return on properties that feel safe — like a new building with a long-term lease to a national tenant in a strong location. That deal might trade at a 4%–5% cap rate.

But if a building is older, in a weaker market, or has short-term leases with uncertainty, investors will want a higher return to take on more risk — which might push the cap rate to 7%–9% or higher.

The cap rate acts like a signal: The higher the cap rate, the more uncertainty investors are pricing in.

That’s why two properties with the same income can have very different prices — because of how the market views the risk behind that income.

Key Takeaways

The cap rate is one of the simplest and most useful tools in real estate — once you know how to apply it.

• It tells you the expected return if you bought a property in cash

• It gives you a quick read on risk — lower cap rate means more stability, higher cap rate means more uncertainty

• It helps you estimate value by comparing a property’s income to what other deals are trading for

If you can remember the formula and what it represents, you’ll already be ahead on top of your game.

Still confused by cap rates or how to use them in your assignment or ahead of an interview? Schedule a 1-on-1 session below and we’ll walk through it together, step by step.