Cap rate (capitalization rate) is the single most-used shorthand metric in commercial real estate for comparing the relative return of income-producing properties. If you already understand conceptually what cap rate measures and want the how-to — the formula, a worked example, and the mistakes that trip people up — this is that guide. For the broader context on what cap rate means and how investors use it strategically, see our Cap Rate 101 post.

This post uses illustrative example figures only. It is not a valuation of any specific property, and does not reflect current market cap rates. Contact us for current ranges relevant to your target property type and market.

The Cap Rate Formula

Cap rate is calculated as:

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

Both numbers need to reflect an annual figure, and NOI needs to be calculated correctly for the formula to mean anything useful.

Step 1: Calculate Net Operating Income (NOI)

NOI is the property’s annual income after operating expenses, but before debt service (mortgage payments), income taxes, and depreciation. The formula for NOI is:

NOI = Gross Operating Income − Operating Expenses

Gross operating income includes rental income plus any other income the property generates (parking fees, laundry income, etc.), minus a vacancy and credit loss allowance. Operating expenses include property taxes, insurance, maintenance, property management fees, and utilities the landlord pays — but not mortgage payments, capital expenditures, or depreciation, since those sit below the NOI line.

Step 2: Divide NOI by Property Value

Once you have annual NOI, divide it by the property’s current market value or purchase price to get the cap rate, expressed as a percentage.

Worked Example

Say a property generates $200,000 in annual gross rental income, has a 5% vacancy and credit loss allowance, and $60,000 in annual operating expenses (taxes, insurance, maintenance, and management combined).

• Gross operating income: $200,000 − (5% × $200,000) = $190,000
• NOI: $190,000 − $60,000 = $130,000
• If the property is priced at $1,850,000: Cap Rate = $130,000 ÷ $1,850,000 = 7.03%

This example is illustrative only — actual NOI calculations should account for every specific expense line item on a given property, and actual cap rates vary significantly by property type, tenant credit, lease structure, and market.

Common Mistakes When Calculating Cap Rate

• Confusing NOI with cash flow. NOI excludes debt service; cash flow (or “cash-on-cash return”) includes it. Comparing a levered cash-flow number to an unlevered cap rate produces misleading comparisons.
• Using inconsistent expense categories across properties. If one offering memorandum includes a management fee in expenses and another doesn’t, the cap rates aren’t actually comparable until you normalize the expense assumptions.
• Trusting the “pro forma” cap rate without verification. Listed cap rates on marketing materials are frequently calculated using optimistic or forward-looking assumptions rather than trailing actual performance. Always ask for trailing 12-month actual financials.
• Ignoring lease structure. A cap rate on a gross-lease property and a cap rate on a true NNN property aren’t directly comparable without adjusting for who pays operating expenses. See our NNN properties guide for how lease structure affects this.
• Not accounting for near-term capital expenditures. A property with a high cap rate but a roof or HVAC system near the end of its useful life may not actually be the better deal once those costs are factored in.

Cap Rate and Property Value Work in Opposite Directions

For a fixed NOI, a lower cap rate corresponds to a higher property value, and a higher cap rate corresponds to a lower property value. This relationship matters when interest rates move — as cap rates compress (get lower) in a low-rate environment, property values rise for the same income stream, and vice versa when rates rise and cap rates widen.

Using Cap Rate to Compare Properties

Cap rate is most useful as a comparison tool across similar property types, lease structures, and markets — comparing a cap rate on a single-tenant NNN property in one market against a multi-tenant gross-lease property in a different market tells you very little without significant adjustment. If you’re evaluating a specific property or comparing multiple opportunities, our commercial property valuation page covers the broader valuation approaches we use beyond cap rate alone.

Frequently Asked Questions

What is a good cap rate? “Good” depends heavily on property type, tenant credit, lease term, and market — a good cap rate for a small owner-user property looks very different from a good cap rate for an investment-grade NNN asset. There’s no universal number; contact us for current ranges relevant to your specific property type and market.

Is a higher or lower cap rate better? Neither is universally “better.” A higher cap rate typically reflects higher perceived risk (shorter lease term, weaker tenant credit, secondary location) and a lower purchase price relative to income. A lower cap rate typically reflects lower risk and a higher price relative to income. The right answer depends on your investment goals.

Does cap rate include the mortgage payment? No. Cap rate is calculated using NOI, which is before debt service. This makes cap rate a measure of the property’s unlevered return, independent of how a specific buyer chooses to finance the purchase.

How do you calculate cap rate on commercial property specifically? The formula is the same for any income-producing property — NOI divided by value or price. What differs for commercial property is often the complexity of calculating an accurate NOI, particularly with NNN leases where expense reimbursements need to be handled correctly.

What’s the difference between cap rate and cash-on-cash return? Cap rate measures return based on the full property value, independent of financing. Cash-on-cash return measures annual pre-tax cash flow (after debt service) against the actual cash invested, which reflects the impact of leverage. The two numbers can differ substantially for the same property depending on financing terms.