Understanding Cap Rates: What They Tell You (and What They Don’t)

Cap rate is one of the most widely used metrics in commercial real estate, but for new investors, it may not be as intuitive as revenue or debt.

It offers a quick way to compare properties and gauge expected outcomes, but its ubiquity can be misleading. A cap rate isn’t a definitive measure of value — it’s just one tool in an investor’s toolkit.

We believe understanding how cap rates work (and what they don’t tell you) is a key step in getting started in the industry. Here’s what every new investor should know.

Cap Rate 101: What is the Cap Rate Formula? 

At its core, a cap rate (short for capitalization rate) is a quick way to assess how much income a property generates relative to its purchase price.

The formula is simple: Cap Rate = Net Operating Income (NOI) ÷ Purchase Price

For example, if a property generates $1 million in NOI and costs $10 million to acquire, its cap rate is 10%. A building with an 8% cap rate might seem like a better deal than one at 6%, if all else is equal.*

Cap rates are often used as a tool to measure an investment's relative risk profile.** ^[1]

A higher cap rate means a property is priced lower relative to its income. These properties may be in less desirable locations, have shorter lease terms, or require improvements.

A lower cap rate can suggest properties may be in desirable locations, have strong tenant demand, or belong to asset classes with generally stable cash flow.*** Sellers can typically justify higher prices for these attributes, which brings cap rates down.

That said, these are generalizations. A cap rate isn’t a definitive measure of a property’s relative risk profile or quality — and various factors can drive it up or down, including interest rates. More on that below.

What are the Limitations of Cap Rates?

Cap rates can be a handy shorthand for comparing properties — especially when you’re looking at deals that are as apples-to-apples as possible. But they leave out a lot. Knowing what cap rates don’t tell you is just as important as knowing what they do.^[2]

Here are three gaps to keep in mind:

• Leverage: Cap rates show an unlevered return — a property’s income relative to its price, without factoring in debt. But, in our experience, most real estate sponsors don’t pay all cash. Financing terms, like interest rates and loan structures, can change the math fast. A high cap rate might look great, but if borrowing costs are steep, it can change the entire outcome of the investment. On the flip side, low-cost financing can potentially make a lower-cap-rate property more attractive.

• Future Cash Flows from Property Improvements: Cap rates are based on a property’s current income, not what it could earn after renovations, lease adjustments, or operational improvements. Value-add strategies can change the property financials, but cap rates alone won’t tell you that story.

• Tenant Risk & Lease Structure: Cap rates don’t tell you much about who’s paying the rent or how secure that income is. A 15-year lease with a Fortune 500 company is a different story than month-to-month deals with local shops. Lease terms matter too. Triple-net leases (where tenants cover expenses) have lower risk of unforeseen expenses than gross leases (where you’re on the hook). The cap rate can’t show you that nuance — you need to dig in.
  
  

What External Conditions Can Impact Cap Rates? 

As mentioned, cap rates don’t exist in a vacuum. They respond to broader market conditions, and several forces can push them up or down. Here are a few of the most common:

Interest rates are one of the biggest drivers. When borrowing is cheap, more investors tend to enter the market and compete for assets, which may drive prices up and compress cap rates. When interest rates rise, financing becomes more expensive, buyers grow more selective, and cap rates often expand.^[3]

Inflation also plays a role. Rising inflation can drive up costs, reduce consumer spending, and raise interest rates, which may expand cap rates and compress asset values.

In other cases, inflation can also lead to rising rents, especially in markets with strong demand or lease structures tied to CPI. That boost to income can help offset cost increases and may even compress cap rates, depending on investor expectations. As with most market forces, the impact of inflation on cap rates depends on a mix of variables — from location and asset type to lease terms and broader economic sentiment.^[4]

Insurance costs and property taxes can also be major swing factors. If the cost to operate a property rises meaningfully, it can affect net operating income — and, by extension, perceived value. In a high-cost or high-risk region (due to climate risk, legal liability, or policy volatility, for example), investors may demand a higher cap rate to compensate for the uncertainty.^[5][6]

While cap rates are often presented as tidy percentages, they’re shaped by an evolving mix of market sentiment, investor expectations, and operating realities. 

Why Do Small Cap Rate Changes Matter?

Even a small change to a cap rate can meaningfully affect how much a property is worth on paper. It’s worth walking through a quick example to see how small shifts can make a big difference for investors.

Earlier, we defined the formula for cap rates. There’s another version investors often use for quick, back-of-the-napkin estimates of a property’s value: Property Value = Net Operating Income ÷ Cap Rate ^[7]

Using that, let’s say a property generates $1 million in net operating income.

• At a 5.00% cap rate, it’s worth $20 million.
• At a 5.25% cap rate, it’s worth $19.05 million.
• At a 6.00% cap rate, it’s worth $16.67 million.

That’s a 16.5% drop in value from just a one-point shift in cap rate.

This example is purely illustrative — but it shows why investors and sponsors keep a close eye on cap rate movements. As interest rates rise or sentiment shifts, cap rate expansion can put downward pressure on asset values, even when income stays the same. Small changes can have big consequences.^[8] 

Learning the Language of Private Markets 

Understanding terms like cap rates is a great first step toward learning the language of private market investing. These jargons get tossed around a lot, and while they might not click right away, a little reading is all it takes to get familiar.

Just keep in mind: some folks talk about cap rates like they’re the whole story, but they’re just one piece of the puzzle. We believe savvy investors consider plenty of other factors when evaluating an opportunity.

Head over to Crowd Street’s Resource Center for more beginner-friendly content on private market investing. You’ll find guides on accreditation, asset classes, and more.

*All examples are hypothetical and for illustrative purposes only. 

**Investment opportunities available through Crowd Street are speculative and involve substantial risk. You should not invest unless you can sustain the risk of loss of capital, including the risk of total loss of capital. All investors should consider their individual factors in consultation with a professional advisor of their choosing when deciding if an investment is appropriate. 

***’Cash-flow’ or ‘Cash-flowing’ when used by Crowd Street in this context refers to investments in which current revenues cover all expenses and typically provide leftover money at the end of the month. This does not mean, however, that this will provide a distribution directly to investors or that the investment will continue to perform in this manner. Distributions are never guaranteed and investing in commercial real estate entails substantive risk. You should not invest unless you can sustain the risk of loss of capital, including the risk of total loss of capital.