Cap Rate Formula for Commercial Real Estate: What It Is and How It Works

Reading Time: 5 minutes

The cap rate formula for commercial real estate is one of the most important metrics for real estate investors to understand. A property’s cap rate can tell you a lot about its potential return on investment, and it’s a pivotal factor to consider when assessing whether or not to buy a property. But what exactly is a cap rate, and how do you calculate it? In this blog post, we’ll answer those questions and more. 

Ground-up view a building surrounding on all four sides.

What is the Cap Rate Formula?

A cap rate measures the return on investment for a commercial real estate property. It is calculated by taking the property’s net operating income (NOI) and dividing it by the purchase price or current market value. 

The formula for calculating the cap rate is as follows: 

  • Cap rate = Net Operating Income / Purchase Price or Value  

How to Calculate Cap Rate

To calculate the cap rate, you must first determine the property’s net operating income (NOI). The NOI is calculated by taking the property’s annual gross income and subtracting all expenses associated with owning and operating the property. These expenses may include property management fees, insurance, taxes, repairs and maintenance, and utilities. 

However, remember that debt payments and mortgage interest are not included when calculating NOI. That’s because some investors purchase a property for cash, while others use different amounts of leverage. Excluding mortgage payments and interest from the NOI makes it easier to do an “apples to apples” comparison of the same property type in the same market.

Once you have the NOI, divide it by the property’s purchase price (or value). This will give you the cap rate as a percentage. 

For example, let’s say you’re looking at a commercial office building with an annual gross income of $1 million. After subtracting all the necessary expenses for owning and operating the property, you’re left with an NOI of $500,000. If you’re looking at purchasing this property for $8 million, your calculation will look like this: 

  • Cap Rate = $500,000 / $8 million = .0625 x 100 = 6.25% 
Two people with laptops calculating on a shared paper.

What is a good cap rate?

A “good” cap rate depends on the investor’s goals and objectives. For example, a lower cap rate with less risk might be more appealing if an investor is looking for income stability. On the other hand, if an investor is seeking high returns, then a higher cap rate property with more risk might be more appealing.

The cap rate is just one factor to consider when making an investment decision. Other factors, such as cash-on-cash return and internal rate of return (IRR), should also be considered.

Cap rate vs. cash-on-cash return

Another important metric to consider when investing in commercial real estate is cash-on-cash return. This measures the annual pre-tax cash flow from a property (including mortgage payments and interest) divided by the total amount of cash invested. In other words, it tells you how much cash you’re making on your investment each year:

  • Cash-on-Cash Return = Annual Pre-Tax Cash Flow / Total Cash Invested x 100 

For example, let’s say you purchase an office building for $8 million with a down payment of $1.6 million. If after deducting all operating expenses, including mortgage payments and interest, from the gross annual income, your annual pre-tax cash flow is $200,000, then your cash-on-cash return would be:

  • Cash-on-Cash Return = $200,000 / $1,600,000 = 0.125 x 100 = 12.5%  

As you can see, the cash-on-cash return is much higher than the cap rate. Both are measures of return, but they focus on different things. The cap rate focuses on the overall profitability of a property, while cash-on-cash return focuses specifically on the cash flow that an investor sees each year.

Strategy flow board with string and pins.

Cap rate vs. IRR

IRR is an acronym for Internal Rate of Return. It’s a measure of profitability that accounts for the time value of money. In other words, it tells you what percentage return on investment you’re getting each year, considering that cash received today is worth more than cash received in the future.

The IRR is important because it allows investors to compare different investments on a level playing field. For example, let’s say you’re considering investing in two different properties. Both properties are expected to generate $100,000 in net income over the next five years. However, Property A will generate that income evenly over the five years, while Property B will generate most of its income in Year 5.

If you simply looked at the expected return on investment, you might think both properties are equally good investments. However, if you take into account the time value of money, you’ll see that Property A is actually the better investment. This is because you’re getting a higher percentage return on your investment each year with Property A.

Moss green Stumptown Coffee Roasters Brew Bar storefront next to a red building front door.

The Bottom Line

The cap rate is just one metric to consider when evaluating a commercial real estate investment. It’s important to understand what it is and how it’s calculated, but it shouldn’t be used in isolation. Other measures of return, such as cash-on-cash return and IRR, should also be considered to get a well-rounded picture of an investment’s potential profitability.

Frequently Asked Questions

Is cap rate the same as ROI?

Cap rate and ROI are two ways of looking at the potential profitability of an investment property. Cap rate looks at the relationship between the property’s sale price or value and its potential annual income. ROI looks at the relationship between the property’s sale price and its potential total return, including the annual income and any asset value appreciation.

Why is lower cap rate better?

It’s also important to keep in mind that a higher cap rate doesn’t always mean a better investment. A property with a higher cap rate may be in a less desirable location or have a significant amount of deferred maintenance leading to higher operating expenses, which could offset the higher return.

right choice.

Similar Articles

Jessica Ho
Jessica Ho
Jessica has 5+ years of experience in journalism and copywriting, with an emphasis on digital content. Prior to joining Crexi's content marketing team, she worked in creative marketing with a freelance portfolio focused on real estate trends and new technologies.

Share This Article