Cap Rates Explained

Return to the 8% building: $100,000 of NOI on a $1,250,000 price. Pay all cash and 8% is your return. But most investors borrow, and leverage changes the story. If you finance $800,000 at, say, 7% interest-only, that debt costs about $56,000 a year, leaving roughly $44,000 of pre-tax cash flow on the $450,000 you put in — a cash-on-cash return near 9.8%. The same asset produces two very different ‘returns’ depending on the capital stack, which is why cap rate and cash-on-cash answer different questions: cap rate values the property, cash-on-cash measures your equity’s performance.

The example also shows the trap. If the in-place NOI was propped up by a below-market tax assessment or an optimistic vacancy assumption, both the cap rate and your cash-on-cash fall the moment reality arrives. That is why the number is a starting point and a thorough due-diligence review is the finish line — and why an experienced commercial broker re-underwrites the seller’s figures rather than trusting the marketing flyer.

Finally, remember what the cap rate leaves out entirely: appreciation, financing terms, tax treatment, and the value you can add through better management or lease-up. Two buildings at the same cap rate can be very different investments if one has below-market rents you can raise on renewal and the other is already maxed out. Treat the cap rate as the headline of the story, not the whole story — it earns a property a place on your shortlist, but the lease structure, the tenant’s credit, the physical condition, and your own business plan for the asset are what determine whether it is actually a good deal for you.

For owner-users — a business buying a building to occupy rather than a pure investor — the cap rate matters differently. Your ‘return’ includes the rent you no longer pay a landlord and the control and equity you build by owning, so a property that looks unremarkable to an investor can be an excellent buy for the right operating business, particularly with SBA financing that allows a low down payment. The lesson holds in every case: define what you are actually solving for — passive yield, appreciation, or occupancy and control — and judge the cap rate against that goal rather than against a number you read somewhere. A broker who understands both the investment and owner-user math will frame the deal around your objective, not a one-size headline. In short, a cap rate is a useful common language for comparing income properties quickly, but it compresses a great deal of risk and opportunity into a single figure. Use it to screen and to talk price, then do the real work — verify the income, read every lease, inspect the building, and model your own financing — before you treat any number as the truth about a deal.