Net operating income is everything
Cap rate equals net operating income (NOI) divided by property value. NOI is the property's income after operating expenses but before mortgage payments and income taxes: gross rent, minus vacancy, minus taxes, insurance, management, maintenance, and capital reserves. Because cap rate excludes financing, two investors paying wildly different mortgage rates on the same building share the same cap rate — that is the point of the metric.
The accuracy of your cap rate lives or dies on the quality of your NOI. Sellers frequently present a "pro forma" NOI that assumes full occupancy and minimal expenses, inflating the apparent return. Always rebuild NOI from actual trailing income and normalized expenses, and include a realistic vacancy allowance and a reserve for big-ticket items like roofs and HVAC systems.
Reading cap rates in context
A "good" cap rate is entirely relative. Class A properties in prime coastal cities trade at 3–5% because investors accept low income in exchange for expected appreciation and stability. Class B/C properties in secondary markets often trade at 6–9%, paying more income to compensate for slower growth and higher risk. A double-digit cap rate should prompt questions, not excitement — it usually reflects real risk.
Cap rate also works in reverse as a valuation tool. Since value equals NOI divided by market cap rate, a small change in prevailing cap rates swings values dramatically: a property earning $50,000 NOI is worth $1,000,000 at a 5% cap rate but only $714,000 at 7%. This sensitivity is exactly why rising interest rates put downward pressure on commercial property values.