What is a good cap rate in commercial real estate?

There's no single good cap rate. It depends on asset class, market, and risk profile. Lower cap rates generally signal lower perceived risk and a higher price paid per dollar of income; higher cap rates generally signal more risk or less competition for the asset. A 5% cap rate in a core market and an 8% cap rate in a secondary market can both be correctly priced for their respective risk levels.

Does cap rate include debt or financing?

No. Cap rate is an unlevered metric, calculated on NOI before any debt service. It reflects the return the property itself generates independent of how it's financed. Two investors using different leverage on the same asset will see the same cap rate but very different cash-on-cash returns.

What is cap rate compression?

Cap rate compression is when market cap rates fall over time, meaning buyers are willing to accept a lower return, and pay a higher price, for the same NOI. Compression increases property values without any change to the underlying operating performance of the asset. The reverse, cap rate expansion, has the opposite effect on value.

How does cap rate affect property value?

Through the rearranged formula, Value = NOI / Cap Rate. For a fixed NOI, a lower cap rate produces a higher implied value, and a higher cap rate produces a lower implied value. This is why the exit cap rate assumption in a hold-period model has such an outsized effect on projected returns.

What Is Cap Rate in Commercial Real Estate? Formula and When It Misleads

The Short Answer

Cap rate (capitalization rate) is Net Operating Income divided by property value, expressed as a percentage. It is the unlevered, single-year return a property produces at a given price, before any financing is layered on. A lower cap rate means investors are paying more per dollar of NOI, usually because they see less risk or more upside.

The Cap Rate Formula

The formula is simple, which is exactly why it gets misused:

Cap Rate = Net Operating Income (NOI) / Property Value (or purchase price)
NOI is the property's income after operating expenses, before debt service and capex. For the full breakdown of what belongs in that number, see our explainer on how NOI is actually calculated.
Property Value is the price paid, or the price you're solving for.

Rearranged, the formula becomes a valuation tool: Value = NOI / Cap Rate. That rearrangement is the whole reason cap rate matters to underwriting. It is not just a return metric, it is how the market prices the asset.

A Worked Example

Say you buy a stabilized asset generating $900,000 in NOI for $15,000,000. The cap rate is:

$900,000 / $15,000,000 = 6.0% cap rate

Now assume nothing changes operationally, but the market for this asset class compresses to a 5.5% cap rate. Rearrange the formula and solve for value using the same NOI:

$900,000 / 0.055 = about $16,363,636

Same building, same income, and the value moved by over $1.3 million purely because the market's required return changed. That is cap rate compression at work, and it is why exit cap rate assumptions matter as much as entry price. Nothing about the property's operations changed between the two scenarios, only the rate the market applied to the same income stream. That distinction, price moving independent of performance, is the part of cap rate that trips up underwriters who treat it as a fixed input instead of a market variable. Run your own numbers with our free cap rate calculator.

Where Cap Rate Misleads

Cap rate is useful precisely because it strips a deal down to one number. That is also its weakness. Watch for these blind spots:

It's a single-year snapshot. Cap rate is almost always calculated on year-one NOI. It says nothing about what happens in year three or year five.
It ignores financing entirely. Cap rate is an unlevered metric. Two buyers can underwrite the same cap rate and get completely different cash-on-cash returns depending on leverage.
It ignores rent growth, capex, and lease rollover. A 6.0% cap rate on a building with leases about to roll to market is a different asset than a 6.0% cap rate on a building with ten years of term left.
It's only as reliable as the NOI behind it. Which expenses were included or excluded changes the number. A seller's pro forma NOI and a buyer's underwritten NOI on the same asset can produce two different cap rates from the same purchase price.
Cap rates don't travel. A 6.0% cap rate in one market or asset class is not directly comparable to a 6.0% cap rate in another without adjusting for risk, growth, and liquidity context.

How It Fits Your Underwriting

Cap rate does two jobs in a real underwriting model: it sets today's value, and through the exit cap rate assumption, it sets tomorrow's. Because exit value is usually the largest single cash flow in a hold-period model, small changes to the exit cap rate assumption move projected IRR a lot, often more than any operational assumption in the deal. For the mechanics of how that plays out across a hold period, see our explainer on IRR in commercial real estate.

The practical implication: never underwrite a deal on entry cap rate alone, and never let an exit cap rate assumption sit unchallenged in a model just because it matches today's market. A model that holds the exit cap rate flat while everything else in the market moves is quietly assuming the future looks exactly like the present, which is rarely a safe assumption over a five or seven year hold. At NextAutomation, we build AI underwriting copilots that pull NOI components, flag inconsistent cap rate assumptions across a deal set, and stress-test exit scenarios automatically, so the number in your model is defensible, not just convenient.

If you want to sanity-check a deal right now, the cap rate calculator takes NOI and price straight to a rate, no spreadsheet required.