Investor Resources

A commercial real estate cap rate is one of the most widely used metrics for evaluating investment properties, but it is also one of the most misunderstood. While a cap rate can provide a quick snapshot of a property's income relative to its value, it does not tell the complete story about an investment's potential returns, risks, or long-term performance.

Understanding what a cap rate measures, and just as importantly, what it does not measure, can help investors make more informed decisions when comparing commercial real estate opportunities.

In this article, we'll explain how the cap rate formula works, the different net operating income (NOI) calculations that can affect the result, what factors influence whether a cap rate may be considered attractive, and the limitations investors should understand before relying on cap rate alone.

What Is a Cap Rate in Commercial Real Estate?

A capitalization rate, commonly called a cap rate, measures the relationship between a commercial property's annual NOI and its purchase price or current market value. It provides a one-year, unlevered snapshot of how much income a property generates relative to its value.

Because the calculation excludes financing, debt service, and future cash flows, a cap rate is best used as a starting point for valuing and comparing investment opportunities. It is not a measure of an investor's total return, annual cash flow, or internal rate of return (IRR).

Commercial Real Estate Cap Rate Formula and Example

The basic cap rate formula is:

Cap Rate = Net Operating Income (NOI) ÷ Property Value or Purchase Price

For example, suppose a commercial property generates $600,000 in annual net operating income and is purchased for $10 million.

$600,000 ÷ $10,000,000 = 0.06, or a 6% cap rate

The relationship also works in reverse. If a property's NOI remains the same but the market requires a higher cap rate, the property's indicated value decreases. Conversely, if market cap rates decline while NOI remains constant, the property's indicated value increases.

This example is provided for illustrative purposes only and is not intended to represent an expected investment return or performance for any Kenwood investment opportunity.

Which NOI Should Be Used to Calculate a Cap Rate?

The cap rate formula may appear straightforward, but the result is only as meaningful as the NOI used in the calculation. Different NOI conventions can produce different cap rates for the same property, making it important to understand how the figure was derived before comparing investment opportunities.

Consistency also matters. A cap rate should be interpreted using the same NOI basis on which it was calculated. Comparing a property using trailing NOI to another using projected NOI, for example, can lead to misleading conclusions if the assumptions behind each figure are not clearly understood.

The table below summarizes the most common NOI conventions used in commercial real estate.

Trailing NOI

Trailing NOI, sometimes called trailing 12-month (TTM) NOI, reflects a property's actual operating performance over the previous 12 months. Because it is based on historical income and expenses, it provides a snapshot of what the property has recently generated rather than what it may produce in the future.

While trailing NOI relies on real operating results rather than projections, it may not reflect contractual rent increases, recent vacancies, expiring leases, or expenses that are unusually high or low during the measurement period. As a result, it may not fully represent the property's expected performance going forward.

Forward or Pro Forma NOI

Forward, or pro forma, NOI estimates a property's expected income over the coming year based on assumptions about occupancy, rental rates, lease activity, operating expenses, and other anticipated changes.

This approach can provide a more realistic view of near-term performance when upcoming lease renewals, rent increases, or operational improvements are expected. However, because it relies on assumptions that have not yet occurred, its accuracy depends on the quality of the underwriting and the sponsor's execution. For that reason, investors should evaluate not only the assumptions behind a pro forma, but also whether the sponsor’s experience, incentives, and long-term strategy support achieving those projected results.

Stabilized NOI

Stabilized NOI estimates the income a property is expected to generate once it reaches normal operating conditions. This approach is commonly used for properties experiencing temporary vacancy, undergoing renovations, or implementing a value-add business plan designed to improve long-term performance.

By estimating income after operations have normalized, stabilized NOI can provide a better indication of a property's long-term earning potential than either trailing or short-term projected results alone. However, like any projection, it depends on assumptions about future leasing activity, operating expenses, and the successful execution of the property's business plan.

What Do Going-In, Stabilized, and Exit Cap Rates Mean?

Cap rates are often described using terms like going-in, stabilized, and exit. While the underlying calculation remains the same, the terminology changes depending on where the property is in its investment lifecycle and which income assumptions are being evaluated. Understanding these distinctions can help investors separate a property's current performance from its projected operating performance and its anticipated value at the time of sale.

Going-In Cap Rate

The going-in cap rate measures the relationship between a property's initial annual net operating income and its acquisition price. It is commonly used to evaluate a property's income-producing ability at the time of purchase and to compare acquisition opportunities.

However, the exact NOI used in a going-in cap rate should always be disclosed. Some investors calculate it using trailing NOI, while others use forward or stabilized NOI. Without understanding the income basis behind the calculation, comparisons between properties can be misleading.

Stabilized Cap Rate

A stabilized cap rate reflects the relationship between a property’s stabilized NOI and its value after it has reached a normalized level of operations. Rather than focusing on temporary vacancies, lease-up periods, or short-term operational disruptions, it reflects the property's expected long-term operating performance once its business plan has been executed.

This measure can be especially useful when evaluating value-add investments or properties undergoing repositioning. However, the resulting cap rate depends not only on the assumptions used to estimate stabilized NOI, but also on the capital improvements, leasing activity, and operational execution required to achieve that stabilized performance.

Exit or Terminal Cap Rate

An exit cap rate, also called a terminal cap rate, is the rate applied to a property's projected future NOI to estimate its potential value at the time of sale. Because the exit cap rate directly influences the projected sale price, even small changes in the assumption can have a significant impact on estimated returns. A modest increase in the projected exit cap rate can reduce the anticipated sale value, while a lower exit cap rate may increase it.

Investors should evaluate exit cap-rate assumptions alongside the property's projected income growth, market conditions, and overall business plan rather than viewing the assumption in isolation.

What Is a Good Cap Rate for Commercial Real Estate?

There is no universal "good" cap rate in commercial real estate. An attractive cap rate depends on the property's characteristics, the local market, the assumptions used to calculate net operating income, and the investor's objectives.

Meaningful comparisons require consistency. Comparing two properties with different asset types, locations, NOI conventions, or transaction dates can lead to incorrect conclusions because each factor influences how the market values income-producing real estate.

In general, a higher cap rate may reflect greater perceived risk, weaker growth expectations, a less competitive investment market, or temporary operating challenges rather than a superior investment opportunity. Likewise, a lower cap rate may indicate stronger investor demand, lower perceived risk, higher expected income growth, or premium asset quality, but it does not eliminate investment risk or guarantee stronger long-term performance.

Instead of asking whether a cap rate is "good," investors should ask whether it is appropriate for the specific property, market, and business plan being evaluated.

The relationship between cap rates and Treasury yields, shown below, also shows why market context matters. CBRE’s H2 2025 Cap Rate Survey found that the all-property cap rate estimate remained relatively steady even as U.S. Treasury yields fluctuated throughout the year. This reinforces that cap rates do not move in direct proportion to interest rates. Property fundamentals, available financing, investor demand, transaction activity, and broader capital flows also influence how commercial real estate is priced.

Property Type, Quality, and Condition

Different commercial property types carry different operating characteristics, leasing dynamics, and capital requirements, all of which can influence how investors price risk.

For example, office, medical, flex, warehouse, retail, and multifamily properties each have unique tenant demands, lease structures, operating expenses, and maintenance considerations. Within each property type, factors such as building age, physical condition, functional layout, deferred maintenance, and anticipated capital improvements can also affect value and investor expectations.

A newer, well-maintained property with modern building systems may be valued differently than an older asset requiring significant renovations, even if both currently generate similar net operating income.

Tenant Mix and Lease Structure

The quality and diversity of a property's tenant base also influence how investors evaluate risk.

Considerations such as tenant concentration, tenant credit quality, lease expiration schedules, contractual rent escalations, renewal probability, and potential downtime between tenants all affect the durability of future income.

For multi-tenant commercial properties, investors often evaluate how staggered lease expirations, diversified tenant mixes, and active asset management may contribute to long-term income stability. At the same time, every property's leasing profile should be evaluated on its own merits rather than relying on broad assumptions about any particular ownership strategy.

Location and Local Market Conditions

Cap rates also vary based on local market conditions. Properties with similar operating performance may be valued differently depending on the metro area, submarket, and competitive environment in which they operate.

Factors such as local employment growth, new construction, tenant demand, vacancy trends, and available investment opportunities all influence investor pricing. For example, investors evaluating commercial properties in Washington, D.C., or Baltimore, should recognize that market conditions can vary significantly between submarkets, even within the same metropolitan region. Understanding local leasing activity, tenant demand, and long-term economic drivers provides important context for interpreting cap rates.

Interest Rates and Capital Market Conditions

Broader capital market conditions can also influence commercial real estate pricing. Treasury yields, borrowing costs, investor return requirements, available financing, market liquidity, and overall transaction activity all contribute to the valuation of commercial properties.

But cap rates don’t move in lockstep with interest rates. While higher borrowing costs may place upward pressure on cap rates in some market environments, property fundamentals, investor demand, available capital, and local market conditions also influence pricing. As a result, changes in interest rates do not automatically produce proportional changes in commercial real estate cap rates.

What Does a Cap Rate Leave Out?

A cap rate is designed to answer a specific question: How much annual net operating income does a property generate relative to its value? Because it focuses on a single year's operating performance, it intentionally leaves out many factors that can influence an investor's overall return.

These limitations don’t make the cap rate an ineffective metric. Instead, they highlight why investors should view it as one component of a broader investment analysis rather than a standalone decision-making tool.

Financing and Debt Service

Cap rate is calculated before mortgage principal and interest payments, making it an unlevered measure of a property's operating performance. As a result, two investors purchasing the same property could experience very different cash flows depending on how each transaction is financed, even though the property's cap rate remains the same.

Investors who want to evaluate how financing affects their annual cash return should also consider metrics such as cash-on-cash return, which incorporates the amount of capital invested and the impact of debt financing.

Capital Expenditures, Tenant Improvements, and Leasing Costs

Cap rate also excludes costs that fall below the NOI line, including capital expenditures, tenant improvements, leasing commissions, and other major ownership expenses.

These costs can have a meaningful impact on an investment's cash flow, particularly for multi-tenant commercial properties. For example, a property may appear attractive based on its current cap rate, but if several tenants are approaching lease expiration, the owner may soon incur significant leasing commissions, tenant improvement costs, or periods of vacancy before replacement tenants begin paying rent. Those expenses are not reflected in the cap rate calculation, even though they directly affect investment performance.

Multi-Year Income Growth and Irregular Cash Flows

A cap rate generally evaluates a single year of operating income. It does not capture how rents, occupancy, operating expenses, or capital needs may change over time, nor does it account for irregular cash flows such as capital improvements, capital calls, or proceeds from a future sale.

When evaluating a long-term investment, investors often supplement the cap rate with multi-period analyses, such as the IRR, which estimates returns over the anticipated holding period rather than a single year.

Future Sale Value and Exit Assumptions

A property's current cap rate does not determine what it will ultimately sell for, nor does it guarantee future appreciation.

An investment's eventual sale value depends on many factors, including future net operating income, prevailing market conditions, property quality, investor demand, and the exit cap-rate assumption used at the time of sale. Because each of these variables can change over the holding period, projected sale values should be viewed as estimates rather than certainties.

How Should Investors Use Cap Rate With Other Metrics?

Cap rate is best viewed as a starting point for evaluating a commercial real estate investment, not the final decision. It provides a useful snapshot of a property's income relative to its value and can help investors compare commercial real estate investment opportunities, but it doesn’t capture all the factors that influence long-term investment performance.

A thorough evaluation considers cap rate alongside other financial and operational measures, including NOI, cash-on-cash return, IRR, equity multiple, debt-service coverage, discounted cash flow (DCF) analysis, replacement cost, and sensitivity analysis. Each metric provides a different perspective on the property's income potential, financing, risk profile, and projected returns over time.

For example, while cap rate helps estimate a property's value based on its current income, cash-on-cash return can help investors understand how financing affects annual cash flow, and internal rate of return (IRR) provides a broader view of projected returns over the anticipated holding period.

Investors should compare opportunities using consistent assumptions and evaluate how the property's business plan, capital requirements, financing structure, and projected cash flows work together over time.

How Kenwood Evaluates Cap Rates in Commercial Real Estate

At Kenwood, cap rate is considered within a broader underwriting process. We evaluate tenant mix, lease rollover, capital needs, financing, local market fundamentals, and projected multi-year cash flows to better understand a property's long-term potential.

Owning, leasing, and managing commercial properties throughout Washington, D.C., and Baltimore gives Kenwood firsthand insight into the local market dynamics that shape underwriting assumptions. That perspective, combined with our long-term ownership approach and in-house property management, supports a more comprehensive investment evaluation than cap rate alone.

Learn more about investing with Kenwood and how we evaluate commercial real estate opportunities for long-term performance.

Understanding Commercial Real Estate Cap Rates

A commercial real estate cap rate can be a valuable comparison tool, but only when the NOI basis, property context, and assumptions behind the calculation are clearly understood. A disciplined investment analysis should also consider future cash flows, capital requirements, financing, market conditions, and the sponsor’s ability to execute the business plan.

To learn more about Kenwood's long-term investment philosophy and commercial real estate underwriting approach, explore our investor resources or learn more about investing with Kenwood.