What Is a Cap Rate (Capitalization Rate)?

Cap rate, discount rate, and internal rate of return (IRR) are frequently confused but measure different things. Cap rate is a single-year snapshot: current NOI divided by current value, with no assumption about future growth or a holding period. Discount rate is the rate used to convert a stream of future cash flows into a present value, reflecting the time value of money and risk over the entire projection period, not just one year.

IRR is the actual return an investor achieves over a full holding period, incorporating cash flow, appreciation, and the timing of every dollar in and out of the deal. A property can have a low going-in cap rate but a high projected IRR if strong NOI growth and cap rate compression are expected, which is why cap rate alone should never be read as a substitute for a full return projection.

Cap rates move with the broader interest rate environment, since real estate competes with bonds and other yield-generating assets for investor capital; when Treasury yields rise, cap rates tend to rise too, all else equal, to maintain an attractive spread. Supply and demand within a specific market and asset class also move cap rates independently of rates, as does the perceived risk of the income stream itself.

A property with long-term leases to investment-grade tenants generally trades at a lower cap rate, a higher price relative to income, than a property with short-term leases to weaker credit tenants, because the market prices the reliability of the income stream, not just its current size, into the valuation.

Capital flows matter too: when large institutional buyers increase allocations to a specific asset class or market, that additional demand can compress cap rates independent of any change in the underlying fundamentals, which is why cap rate trends should be read alongside transaction volume, not treated as a pure measure of an asset's income risk.

Going-in cap rate is calculated on the NOI and price at acquisition; exit cap rate is the cap rate assumed at sale, applied to the projected NOI in the final year of the hold. Underwriting typically assumes the exit cap rate is flat or slightly higher than the going-in cap rate as a conservative buffer, since cap rates tend to expand rather than compress over a long enough time horizon.

A projection that assumes meaningful cap rate compression at exit, selling for a lower cap rate than the property was bought at, adds real risk to the return projection, since that assumption depends on market conditions the sponsor cannot control, unlike NOI growth, which the sponsor can influence directly through operations.

As an illustration, a sponsor buys a property generating $500,000 in NOI at a 7.0% cap rate, implying a purchase price of about $7,140,000. Through renovation and lease-up, NOI grows to $650,000 over three years. If the market cap rate for stabilized assets in that submarket has also compressed to 6.5% by the time of sale, the property is worth roughly $10,000,000.

That value increase comes from two separate sources: NOI growth contributed about $2,140,000 of the gain on its own, the NOI increase divided by the original 7.0% cap rate, while cap rate compression contributed the remainder, illustrating why sponsors should separate operational value creation from market-driven appreciation when evaluating how much of a return came from skill versus timing.

Cap rate can be distorted by non-recurring income, deferred capital expenditures not reflected in the NOI calculation, or a seller's optimistic pro forma NOI rather than trailing actual income, so a quoted cap rate should always be checked against how the underlying NOI was calculated before being used to compare properties. Two properties advertised at the same cap rate can carry very different real risk once the income behind each number is examined closely.

Cap rate also says nothing about lease rollover risk or future capital needs on its own. A property at a 7% cap rate with three years remaining on a single major lease carries very different risk than a property at the same cap rate with ten years remaining on diversified leases, even though the single-year snapshot looks identical, which is why serious underwriting always looks past the cap rate to the lease expiration schedule behind it.