What cap rate measures
Cap rate is net operating income divided by value. It expresses what the market charges for a dollar of NOI. A 5% cap means buyers pay twenty dollars per dollar of income; an 8% cap means twelve and a half.
Why a higher cap rate is not better
Higher cap rates compensate for higher risk: weaker markets, older assets, shorter leases, worse tenant credit. A 4.5% cap in a supply-constrained coastal submarket and an 8.5% cap in a tertiary market can carry identical risk-adjusted returns. Chasing cap rate without understanding what is being priced is how investors buy risk they did not intend to own.
What it is good for
Comparing similar assets in the same submarket, and translating NOI into value. Because it excludes financing, it is the right tool for evaluating the property. Use cash-on-cash return to evaluate the deal, and IRR to evaluate the hold.
Frequently asked questions
Should I use the seller's cap rate?
No. Compute it from your own underwritten NOI at the asking price.
What about pro forma cap rate?
Treat it as the upside case, never the base case.