Cap Rate Explained: Formula, Examples and Common Mistakes
Cap rate is net operating income divided by value. Learn the formula, going-in versus exit cap rates, and why a small change moves value so much.
Key takeaways
- Cap rate = net operating income / value. It is a first-year unlevered yield, not a total return.
- A 0.5 point rise in exit cap rate from 6.0% to 6.5% cuts value by about 7.7%.
- Apply the exit cap rate to the following year's income and justify any rate below the going-in rate.
A capitalisation rate, or cap rate, is a property's net operating income divided by its value. It is the unlevered yield a buyer would earn in the first year if they paid cash. Cap rate is also used in reverse: divide income by a cap rate and you get an estimate of value.
The formula
Cap rate = net operating income / property value. A building producing $600,000 of net operating income that sells for $10,000,000 trades at a 6.0% cap rate. Rearranged, value = net operating income / cap rate, which is how most models estimate the sale price at exit.
Going-in versus exit cap rate
The going-in cap rate is year-one income divided by the purchase price. The exit cap rate is the rate assumed at sale, applied to the income a buyer would expect in the following year. Most analysts assume an exit cap rate somewhat above the going-in rate, on the basis that the building will be older and that market conditions at sale are unknown. An exit rate below the going-in rate needs a specific justification.
Why small changes matter so much
Suppose income at exit is $700,000.
- At a 6.0% exit cap rate, value is about $11,670,000.
- At a 6.5% exit cap rate, value is about $10,770,000.
Half a percentage point removes roughly $900,000, or 7.7% of the value. With debt in place, the effect on equity is far larger, because the loan balance does not fall with the value. This is why the exit cap rate is usually the most sensitive assumption in an acquisition model.
Common mistakes
- Using income that is not net operating income: check that taxes, insurance and management are deducted and that debt service is not.
- Comparing cap rates across properties with different lease lengths, tenant quality or capital needs.
- Applying the exit cap rate to the final year's income instead of the following year's.
- Treating cap rate as a total return. It ignores growth, capital expenditure and financing.
Cap rate in a model
Cap rate is a snapshot. A model is what turns it into a decision, by adding income growth, capital costs, debt and the exit. In our acquisition models the exit cap rate always sits on the assumptions sheet with a sensitivity table beside it, so reviewers can see how much of the return depends on it. If you need the income figure first, see how to calculate net operating income.
Frequently asked questions
What is a good cap rate?
There is no universal good cap rate. Lower rates indicate higher prices and usually lower perceived risk; higher rates indicate the opposite. The right comparison is against similar properties in the same market and against the cost of debt.
Does cap rate include the mortgage?
No. Cap rate uses net operating income, which is calculated before debt service. It describes the property, not the financing.
How is cap rate different from yield?
The terms are often used interchangeably. In UK practice 'net initial yield' is the close equivalent and is quoted after purchaser's costs, so the two figures can differ slightly for the same property.