The capitalization rate (cap rate) is the fundamental valuation tool in commercial real estate — a ratio that converts a property's net operating income (NOI) into an estimate of market value. The formula is simple: Cap Rate = NOI / Value, or equivalently, Value = NOI / Cap Rate. A property generating $1 million of annual NOI in a market where comparable properties trade at a 5% cap rate implies a market value of $20 million. At a 6% cap rate, the same NOI implies a value of $16.7 million.
Cap rates reflect the market's required yield on real estate — analogous to a stock's earnings yield or a bond's yield-to-maturity. Lower cap rates indicate higher property values relative to income (and lower required yields), typical in high-demand urban markets with strong growth prospects. Higher cap rates imply lower prices relative to income and higher required yields, typical in secondary markets, less desirable property types, or riskier situations.
Cap rates are driven by several factors: interest rates (as risk-free rates rise, real estate required yields tend to rise, pushing cap rates higher and values lower), income growth expectations (markets with strong rent growth support lower cap rates), property quality and lease structure, and general risk appetite in capital markets. The spread between cap rates and risk-free rates (like 10-year Treasury yields) is a measure of the incremental yield investors require for holding real estate risk.
For credit analysis, cap rate assumptions are critical inputs to LTV calculations. If a lender makes a $10M loan on a property with $600K of NOI at a 6% cap rate (value = $10M, LTV = 100%), and cap rates subsequently expand to 7%, the implied value drops to $8.57M — and the LTV jumps to 117%, with the loan immediately underwater. Understanding cap rate sensitivity is essential for stress-testing CRE loan underwriting.
The "going-in" cap rate (the cap rate at acquisition, based on current NOI) and the "exit" or "terminal" cap rate (the assumed cap rate at disposition) are distinct inputs in CRE investment analysis. Investors typically underwrite exit cap rates at a premium to going-in rates — a conservative assumption reflecting uncertainty about future market conditions. Lenders should scrutinize whether the exit cap rate assumptions embedded in a borrower's underwriting are realistic relative to current market conditions.