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.
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.
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.
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.
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.