The following is more of an academic discussion of what a Capitalization rate (“Cap Rate”) is; however, having this background knowledge is critical to understanding an investment opportunity and being able to point out BS sales marketing tactics.

The Cap Rate is an assessment used by a real estate investor to help determine the financial health of an investment.

With the current market trends, there has been continual cap rate compression, bringing down the potential return. Despite that, we strongly feel that cash flow investing in recession-resistant assets is a prudent investment strategy rather than having your cash sit on the sidelines as lazy equity.

How to calculate a Property’s Cap Rate

The formula is as follows:

Example: Cap Rate Calculation w/ Financing

A passive investor puts 25% down for the purchase of an $8.5M property.
Finances $6,375,000 on a 25-year amortization at 5.05%, which creates an annual debt service of $449,448.00
The lender’s return on this property investment (known as the mortgage constant) is 7.1% ($449,448 /$6,375,000)
The NOI to the passive investor after the mortgage would be $276,897, creating an investor’s equity return of 13.0% ($276,897 / $2,125,000 down payment). This is also known as the cash-on-cash return.

When weighted based on the loan-to-value/equity position, the cap rate is verified.

Loan-to-Value 75% x 7.1% mortgage constant = 5.3% lender’s cap rate
Equity Position at 25% x 13.0% cash-on-cash return = 3.2% investor’s cap rate
Capitalization Rate (5.3% + 3.2%) = 8.5%

This splitting of the cap rate into the lender’s cap rate and the investor’s cap rate is called the Band of Investment Method. It can be used to back into a purchase price once the lending terms are set and the investors’ desired ROI is known.

Analyzing Cap Rates for the Best Apartment Type

See graphics below for analysis of cap rates in multifamily. Note that these are based on the overall 12-month compressed cap rate.

“Garden-Style” is the 1-3 story Class B or C apartments that many of us like to buy for optimal returns.

What Does the Cap Rate Tell You?

Return on Cash Investment

The cap rate helps an investor determine the percentage of return they can anticipate if they purchased the investment property for cash, assuming the income and market value remain constant

Investment Comparison

It can also be a useful tool to compare different types of investment properties. For example, if an apartment building is listed for $1,250,000 and has an NOI of $92,500, the cap rate would be 7.4%. Whereas if a mobile home park is listed for $435,000 and is generating a NOI of $37,500, the cap rate is 8.6%. The higher the cap rate, the better the return on the investment, making the mobile home park a more appealing option, at least at this point in the analysis.

Risk Assessment

The cap rate has a risk/return buried in the rate. If an investor has $1,000,000 to invest, they could place it all in a 10-year treasury bond and be guaranteed a 3% return on their investment.

If they purchased an apartment building that generates $100,000 annually, they would get a 10% return on their investment. The 7% difference reflects the additional risk associated with managing an apartment building compared to the bond investment.

Fannie Mae has different tiers of markets, which correlate with the caps of the market. Tier 1 markets like San Francisco, New York, Los Angeles… places we would not invest in because there is no cashflow, have the lowest caps (2%-5%). Tertiary markets have higher caps (5%-8%).

What Does the Cap Rate NOT Tell You?

Irregular Income and Expenses

The capitalization rate assumes that the NOI will remain constant. If the property’s net operating income stream is complex, such as with percentage-based rent rates, the cap rate will not be able to provide an accurate picture. The more complex Discounted Cash Flow (DCF) analysis will need to be completed.

Additionally, inaccurate income or expenses will dramatically affect the capitalization rate. So you need to verify the Profit and Loss Statements.

Cash-on-Cash

A cap rate assumes a cash purchase. Financing will affect the investor’s ROI. The cap rate will then need to be split between the return on the lender’s investment and that of the investor.

When is it a good time to buy?

Investors make money on the delta or spread between the cap rate and the interest rate… times the leverage (loan). So as long as there is a spread, the investor makes money. Traditionally, Cap Rates and Interest rates move as a pair. See below, which I found as the best academic example for this.

Self Storage Cap Rates vs. Interest Rates

What is the current/prevailing cap rate of a market, so I can compare it with the reversion/exit cap rate? Refer to charts like these. Note – there is a large range based on asset class and sub-market within the MSA.

The best time to invest was yesterday!

Conclusion and Key Takeaways

Cap Rate Is a Baseline Valuation Metric – The capitalization rate (NOI ÷ Purchase Price) helps investors estimate returns on an all-cash basis and compare different real estate assets at a high level.

Cap Rate Compression Lowers Returns – As cap rates have dropped in recent years, it’s become harder to find high-yielding deals. This makes it even more important to invest in cash-flowing, recession-resistant assets.

Cap Rate Doesn’t Equal Cash-on-Cash – Cap rate assumes a cash purchase and ignores financing. Cash-on-cash return reflects leverage, debt service, and actual investor return—use both metrics, but don’t confuse them.

The Band of Investment Method Can Reverse Engineer Purchase Price – By calculating both lender and investor returns based on capital structure, investors can back into a fair purchase price based on desired returns.

Cap Rates Reflect Risk – A higher cap rate usually means more perceived risk (tertiary markets, Class C assets), while lower cap rates are tied to “safe” core assets in Tier 1 markets—but often come with weak or no cash flow.

Cap Rates Don’t Show Future Growth – Cap rates assume income and expenses stay constant. They don’t capture value-add potential or expense fluctuations, so deeper underwriting is needed for deals with dynamic business plans.

Cap Rate vs Interest Rate Spread Drives Profit – Investors benefit when the cap rate exceeds the interest rate. This spread, multiplied by leverage, creates the yield. When the cap and interest rates are close, returns get squeezed.

Reversion Cap Rate Matters at Exit – Always compare the going-in cap rate with the reversion (exit) cap rate. Assuming the cap rate stays the same or improves can artificially boost projected returns—use conservative estimates.

Don’t Rely on Broker Proformas Alone – Cap rate is only as accurate as the NOI it’s based on. Always verify P&Ls and rent rolls to ensure you’re not pricing the deal based on inflated or irregular income.

Different Asset Types Have Different Caps – Multifamily, commercial real estate, mobile home parks, and self-storage all trade at different cap rates. Compare apples to apples when evaluating deals, and understand how cap rates vary by market and submarket.

This is educational content, not tax, legal, or investment advice. We are not attorneys, CPAs, or financial planners. Please let us know if you need a referral to a 💼 CPA, ⚖️ Lawyer, or other vendor here.

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