Capitalization Rate (Cap Rate)

The capitalization rate (cap rate) is the ratio of a property's net operating income (NOI) to its market value. It expresses what an income-producing property yields before financing: a building generating 6 million dollars of NOI valued at 100 million dollars trades at a 6 percent cap rate.

Cap rates work like an inverse multiple: a lower cap rate means a higher valuation per dollar of income, just as a higher P/E means a more expensive stock. Prime assets in strong markets command low cap rates; riskier properties and weaker locations require higher ones.

Cap Rates and REIT Valuation

Cap rates are the engine of net asset value (NAV) analysis for REITs: apply a market cap rate to the portfolio's NOI to estimate what the properties are worth, subtract net debt, and compare the result to the REIT's market capitalization. Trading far below NAV can signal opportunity; persistently above NAV, optimism.

Because value moves inversely with the cap rate, small shifts matter enormously. Rising interest rates tend to push cap rates up and property values down — which is why REITs are sensitive to the rate cycle even when rents are stable.