Finance term
Capitalization Rate (Cap Rate)
Also known as: cap rate, capitalization rate, real estate cap rate
Definition
Cap rate is a real estate metric that expresses a property's net operating income (NOI) as a percentage of its purchase price — used to evaluate income-producing properties and relevant to SBA 504 buyers and commercial real estate investors.
Detailed explanation
The capitalization rate (cap rate) formula is: Cap Rate = Net Operating Income (NOI) / Property Value. NOI = gross rental income minus operating expenses (taxes, insurance, management, maintenance, utilities, vacancy allowance) but before debt service and depreciation. If a property has $120,000 NOI and trades at $1,500,000, the cap rate is 8%.
Cap rate serves two functions: (1) as a valuation metric — comparing a property's income yield to market cap rates for similar assets; (2) as a risk measure — lower cap rates indicate higher prices relative to income (lower yield, more expensive market, less risk), while higher cap rates signal more risk or less desirable locations. In major coastal markets, multifamily cap rates may be 4-5%; in secondary Midwest markets, 7-9% for comparable properties.
For SBA 504 and conventional commercial real estate loans, lenders use cap rate analysis alongside DSCR to evaluate the property's income adequacy. A property bought at a 5% cap rate with debt at 7% is immediately cash-flow negative (negative leverage). Understanding the relationship between cap rate and debt cost is fundamental to commercial real estate underwriting.
◈ Worked example
- Strip mall: $800,000 NOI / $10,000,000 purchase price = 8% cap rate. Market cap rates for similar assets in that market: 7.5-8.5%. Property is at fair market value.
- Office building: $200,000 NOI / $4,000,000 = 5% cap rate. SBA 504 debt at 6.5% — negative leverage. Buyer expects NOI to grow to cover debt service within 2-3 years.
- Cap rate compression example: a property bought at 8% cap for $1.25M ($100K NOI) in 2020. Market cap rates compress to 6% by 2024. Same $100K NOI / 6% = implied value $1.67M — 33% appreciation.
Common questions
The most-asked questions about Capitalization Rate (Cap Rate) — answered straightforwardly.
What is a good cap rate for a commercial real estate investment? +
It depends entirely on market, asset class, and your financing rate. A 7% cap rate in a 7% interest rate environment may be neutral. A 7% cap rate when you can borrow at 5.5% produces positive leverage. Generally: lower cap rates = more expensive, more desirable markets; higher cap rates = secondary markets, higher risk, or distressed situations. There is no universal 'good' cap rate without context.
Does cap rate include mortgage payments? +
No. Cap rate is calculated before debt service. It reflects the property's operating yield on an unlevered basis. To account for financing, use cash-on-cash return (levered yield), which divides annual cash flow after debt service by the equity invested.
How is cap rate used in SBA 504 loans? +
SBA 504 lenders evaluate whether the property's NOI supports the proposed debt service. If the cap rate is significantly below the 504 blended interest rate, the property will be cash-flow negative from day one — which may not be acceptable unless the business occupying the building generates sufficient other income to cover the shortfall. Owner-occupied buildings often have this structure by design.
Further reading
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