What Is a Good Cap Rate in Commercial Real Estate?

A capitalization rate, often called a cap rate, is a fundamental metric in commercial real estate. It measures a property’s unleveraged yield, reflecting the income generated relative to its value without considering debt financing. For investors, understanding the cap rate is important for evaluating a property’s potential profitability, comparing investment opportunities, and informing initial decisions.

Understanding Cap Rate

A capitalization rate is calculated by dividing a property’s Net Operating Income (NOI) by its current market value or purchase price. The formula, Cap Rate = NOI / Property Value, provides a percentage representing the annual return an investor could expect if the property were acquired with cash. Net Operating Income is the total revenue generated by a property after subtracting all operating expenses. These expenses include property taxes, insurance, utilities, repairs, and property management fees. NOI excludes non-operating costs such as mortgage principal and interest payments, capital expenditures, depreciation, and income taxes.

To illustrate, consider a commercial property generating $150,000 in annual gross operating income. If its annual operating expenses total $65,000, the Net Operating Income would be $85,000. If this property is valued at $1,700,000, its capitalization rate would be 5% ($85,000 NOI / $1,700,000 Property Value). This 5% indicates the unleveraged annual return based on the property’s income and value.

Factors Influencing Cap Rate

Cap rates fluctuate due to various internal and external factors, meaning there is no single universal “good” rate. Different property types carry distinct risk profiles, which are reflected in their typical cap rates.

For example, multifamily properties often exhibit lower cap rates, generally ranging from 5.0% to 6.5%, with Class A assets around 4.74% in early 2025, due to stable demand and consistent income streams. Industrial properties, driven by strong e-commerce demand, typically see cap rates between 5.5% and 7.5%, averaging around 6.7% in 2024-2025. Retail property cap rates average 6.4% to 6.65% in early 2025, with variations based on tenant quality and consumer spending. Office properties generally have higher cap rates, with Class A assets exceeding 8% and Class C properties reaching into the low teens, reflecting weaker demand and higher vacancy rates. Hotels, influenced by market recovery and higher financing costs, can have average cap rates around 7.3%, with ranges from 3.3% to 10.6%.

Location plays a role, with properties in high-demand urban areas often commanding lower cap rates due to perceived stability and higher demand. Suburban or less desirable locations tend to have higher rates. Broader market conditions, such as interest rates, also influence cap rates. When interest rates rise, borrowing costs increase, which can reduce investor demand for real estate and lead to higher cap rates and lower property valuations. Conversely, lower interest rates can make financing more affordable, driving up property prices and compressing cap rates.

The financial strength of tenants and lease terms are important determinants. Properties with financially strong tenants and long-term lease agreements typically present lower perceived risk, resulting in lower cap rates. Leases with rent escalation clauses or those in strong demand markets can positively influence NOI and cap rates. The physical condition and age of a property also affect its cap rate; newer properties or those in excellent condition often have lower cap rates because they incur fewer maintenance issues and attract higher-quality tenants. Higher perceived risk generally translates to higher cap rates, as investors demand a greater return.

Interpreting a Good Cap Rate

There is no universally defined “good” cap rate; its desirability depends on the investor’s specific goals, risk tolerance, and the property’s unique characteristics and market. Investors typically evaluate a property’s cap rate by comparing it to market averages for similar properties in the same submarket and property type. For instance, a 5% cap rate might be suitable for a stable, low-risk multifamily asset in a prime urban location, but it could be considered too low for an older, higher-risk property in a less desirable area.

A lower cap rate generally indicates lower perceived risk and potentially higher appreciation, often appealing to investors seeking long-term stability and capital growth. Conversely, a higher cap rate often suggests a higher risk profile but can offer greater immediate cash flow. An investor focused on stable income might prioritize a property with a moderate cap rate that aligns with predictable cash flows. In contrast, an investor pursuing significant appreciation or redevelopment opportunities might accept a higher-risk property with a higher cap rate, anticipating future value creation.

The prevailing interest rate environment influences investor expectations for cap rates. When interest rates are elevated, investors may require higher cap rates to justify the investment, as alternative, less risky investments like bonds may offer competitive returns. Conversely, in a low-interest-rate environment, investors might accept lower cap rates. The capitalization rate is one of several important metrics to consider when evaluating commercial real estate, and it should be analyzed within the broader context of market conditions and individual investment strategies.