What Is a Cap Rate?

A capitalization rate, or cap rate, expresses a property’s annual net operating income as a percentage of its purchase price or market value.

Cap Rate = Net Operating Income ÷ Purchase Price

Net operating income, or NOI, is the income remaining after property operating expenses, before mortgage payments, income taxes, depreciation, or leasing commissions. Cap rate helps investors compare income-producing properties, but it does not represent their total investment return.

So, that’s the calculation. What does it mean, and why does it vary?

Why do cap rates fluctuate?

Investors’ expectations change. Tenant credit, remaining lease term, location, property condition, and opportunities for rent growth all influence what buyers are willing to pay. Interest rates, financing costs, and competition from other investments also affect the yields they seek.

Individual buyers bring their own preferences, but market cap rates reflect what buyers and sellers actually agree to in comparable transactions.

Let’s look at an example.

Consider a hypothetical single-tenant net-leased investment occupied by Walgreens, with 12 years remaining on an absolute NNN lease. Assume the tenant is responsible for the property’s operating expenses and maintenance, leaving the landlord with minimal day-to-day involvement.

If annual rent produces $250,000 in NOI, Investor A might be willing to buy the property at a 5.5% cap rate:

$250,000 ÷ 5.5% = approximately $4,545,000

At that price, the property generates annual operating income equal to 5.5% of the purchase price, before financing and income taxes. The investor accepts that yield because she values the long lease and predictable income.

Now consider a small strip center with 12 mostly local tenants. It produces $200,000 in annual NOI—not simply gross rent. The owner must oversee maintenance, renewals, vacancies, and leasing.

Investor A may want a higher yield to compensate for the uncertainty and greater management demands. At a 9% cap rate, she would value the property at:

$200,000 ÷ 9% = approximately $2,222,000

But Investor B may see the same property differently. She likes having multiple tenants: if one leaves, the others continue paying rent. A single-tenant property concentrates that risk in one tenant. If that tenant stops paying, the property could lose all rental income. Closing a store, however, does not necessarily end the tenant’s obligation to pay rent.

Investor B may therefore accept an 8% cap rate for the strip center:

$200,000 ÷ 8% = $2,500,000

Investor Pro Tip: Before comparing cap rates, ask whether the NOI reflects actual income or projected income. A higher advertised cap rate may assume full occupancy, future rent increases, or understated expenses. Verify the numbers behind the percentage so you’re comparing properties on the same basis.

That one percentage point changes the indicated value by nearly $278,000, even though the property’s income is exactly the same.

For the same NOI, a lower cap rate means a higher price. A higher cap rate means a lower price.

Ultimately, cap rate connects a property’s income to the price an investor is willing to pay. A higher cap rate may offer a greater income yield, but it can also reflect greater perceived risk. A lower cap rate may reflect more predictable income or stronger growth expectations. The key is to look beyond the percentage and understand the tenants, lease terms, expenses, and market conditions supporting it.