Cap Rates Explained

If you’re just starting in commercial real estate, you’ve probably heard the term “cap rate” tossed around like it’s magic. Spoiler: it kind of is — but it’s not complicated. A cap rate, short for capitalization rate, is simply a way to measure how much income a property generates compared to what it costs. Think of it as your first “gut check” for whether a deal makes sense.

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How to Calculate Cap Rate

To find the cap rate for a property, you use the following formula:

Let's do a quick and easy example. A property brings in $100,000 a year after expenses (that’s your NOI). It’s listed for $1,000,000 (that's your property value). Plug it in:

Boom. That property has a 10% cap rate. Easy, right?

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Why Cap Rates Are Useful

Cap rates give you a quick peek at return and risk:

• Higher cap rates mean higher potential return but also higher risk
• Lower cap rates mean lower risk, but you’ll likely pay more for stability

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It’s a simple way to compare properties or figure out if a listing is priced fairly without getting buried in spreadsheets.

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Here's The Catch

Cap rates don’t tell the whole story. They don’t include:

• Financing costs
• How rents or expenses might change over time
• Tenant and lease risks
• Management efficiency
• Market-specific risks

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Think of them like a first impression; they help you spot deals worth a deeper look.

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How Investors Actually Use Cap Rates

1. Quick Value Check: “Does this building make sense at this price?”
2. Market Comparison: Compare similar buildings in the same city or neighborhood.
3. Risk Gauge: Higher cap rates can signal higher risk, letting you decide if it’s worth it.

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Disclaimer: This content is meant for informational purposes only and is not intended to be construed as financial, tax, legal, or insurance advice.