What Is a Cap Rate? A Complete Guide for Commercial Real Estate Investors
Capitalization rate, or cap rate, is the most widely used metric in commercial real estate investing. It measures a property’s income relative to its value, giving investors a fast way to compare properties and gauge expected returns. Understanding how to calculate it, what it means, what moves it, and what it does not tell you is foundational to evaluating any commercial investment.
Cap rate, in one line.
What a cap rate actually measures.
A cap rate answers a simple question: what percentage of the price does this property return in income each year if you pay all cash? A 6 percent cap rate means roughly 6 dollars of income for every 100 dollars of price, before any mortgage.
The calculation starts with net operating income, which is gross rent minus operating expenses and excludes debt service. You divide that NOI by the purchase price to get the cap rate.
Cap rates exist to normalize comparisons. They let you put a 500,000 dollar building and a 5 million dollar building on the same scale and compare their yields directly.
Their danger is their simplicity. A single number cannot capture tenant credit, lease term, rent growth, building condition, or where a neighborhood is headed. A cap rate is a starting point, not an ending point.
A cap rate tells you the yield at today’s NOI and today’s price. It does not tell you if the NOI is sustainable, whether the tenant will renew, or if the neighborhood is improving or declining. Always look behind the number.
How NOI is calculated.
At a $985,000 purchase price: $59,010 ÷ $985,000 = a 5.99% cap rate. Note that NNN leases pass property taxes, insurance, and maintenance through to the tenant, which significantly simplifies the NOI calculation.
Cap rates by property type in Sacramento, 2026.
These ranges are a current market reference for Greater Sacramento, not guarantees.
NNN Retail, National Credit Tenant · 5.0 to 6.0%
Investment-grade national tenants such as McDonald’s, Dollar General, CVS, or Starbucks on 15 to 20 year terms with corporate guarantees. The lowest risk and the lowest cap rate, and the most passive. Compressing 5 to 15 basis points in 2026 as rates ease.
Industrial & Warehouse · 5.5 to 6.5%
Strong in Sacramento’s distribution position with tight vacancy. Flex space sits at the higher end, large-format logistics at the lower end. Fundamentals stabilizing after the 2023 to 2024 expansion.
Medical Office · 5.5 to 6.5%
Long leases, high tenant buildout, and low relocation risk. A healthcare employment base drives demand. A defensive income asset, grouped with NNN.
Neighborhood & Strip Retail · 5.5 to 7.0%
Multi-tenant, with the range reflecting tenant quality, location, and anchor. Grocery-anchored centers price lower, unanchored strips higher. Underwriting the tenant mix is critical.
Office · 6.5 to 8.5%+
The most bifurcated category. Prime Class A with long leases prices lower, older suburban or Class B and C with near-term expirations prices higher. National vacancy near 18.7% means strong underwriting is required.
NNN Retail, Shorter Term or Local Tenant · 6.5 to 8.0%+
The same NNN structure but with under seven years remaining and a franchisee or local operator without national credit. Lease term and guarantor type drive the value.
Market reference figures as of early 2026 for Greater Sacramento. Not investment advice. Verify current pricing for any specific property.
What pushes cap rates up or down.
Tenant Credit Quality
Stronger credit pushes the cap rate lower. A national investment-grade tenant is priced very differently from an untested local operator.
Lease Term Remaining
A longer remaining term pushes the cap rate lower. Fifteen years of contracted income is worth more than two.
Location Quality
A prime location pushes the cap rate lower. Folsom, Roseville, and El Dorado Hills command tighter pricing than secondary submarkets.
Rent Growth Expectations
Strong rent growth potential pushes the cap rate lower, because buyers will pay more today for income they expect to rise.
Interest Rates
Lower rates push cap rates lower and values higher. Industry forecasts pointed to roughly 5 to 15 basis points of compression across property types in 2026.
Physical Condition & Capital Needs
Good condition pushes the cap rate lower. Deferred maintenance and looming capital expenditures push it higher to compensate the buyer.
Cap rate mistakes that cost investors money.
Two habits protect investors more than any other. First, verify the NOI behind a seller’s stated cap rate. Second, never use the cap rate in isolation. A 7 percent yield on a struggling two-year tenant is not the same investment as a 5.5 percent yield backed by a fifteen-year corporate lease.
Trusting Pro Forma NOI
A seller’s stated cap rate often rests on projected income, not actual income. Always verify the NOI behind the number with real rent rolls and expenses.
Ignoring Lease Term Remaining
A 7 percent cap rate on a tenant with two years left can be far riskier than a 5.5 percent cap rate on a fifteen-year corporate lease.
Excluding Management Costs
Owners who self-manage sometimes leave management out of NOI, which inflates the cap rate. Underwrite a market management cost even if you plan to self-manage.
Ignoring Capital Expenditure Reserves
Roofs, HVAC, and parking lots wear out. A cap rate that ignores reserves overstates the real return.
Chasing High Cap Rates Without Context
The highest cap rate on the market is usually the highest for a reason. Read every number against tenant credit, term, location, and condition.
Talk through a specific investment.
A cap rate is only as good as the underwriting behind it. If you are evaluating a property, walk the numbers through with an advisor before you write the offer.
What cap rate does not tell you: other key metrics.
Cash-on-Cash Return
The return on the actual cash you invest after financing. When the loan rate is below the cap rate you have positive leverage and your cash-on-cash exceeds the cap rate. When it is above, leverage works against you.
Debt Service Coverage Ratio (DSCR)
How comfortably the property’s income covers its loan payment. Lenders typically require a minimum of 1.20 to 1.25 times before they will fund a commercial loan.
Internal Rate of Return (IRR)
The total annualized return over your full hold, including the eventual sale. IRR captures rent growth, loan paydown, and exit value that a single-year cap rate cannot.
Cap rate, frequently asked questions.
A capitalization rate is a property’s net operating income divided by its price or value, expressed as a percentage. It represents the annual return you would earn paying all cash, before financing and income taxes. A 6 percent cap rate means the property produces 6 dollars of income for every 100 dollars of value. It is the fastest way to compare income-producing properties on the same scale.
It depends entirely on the property type and the risk. In Greater Sacramento today, national-credit NNN retail trades around 5.0 to 6.0 percent, industrial and medical office around 5.5 to 6.5 percent, multi-tenant retail around 5.5 to 7.0 percent, and office anywhere from 6.5 to 8.5 percent or higher. A lower cap rate is not automatically worse. It usually reflects stronger tenant credit, a longer lease, or a better location.
Not on their own. A higher cap rate usually signals higher risk: a shorter remaining lease, weaker tenant credit, a secondary location, or looming capital needs. A 7 percent cap rate on a struggling tenant with two years left can be a worse investment than a 5.5 percent cap rate backed by a fifteen-year corporate lease. Always read the cap rate in context.
Net operating income is the property’s gross rental income minus all operating expenses, before mortgage payments and income taxes. Operating expenses include property taxes, insurance, maintenance, and management. On a triple-net lease, the tenant pays taxes, insurance, and maintenance directly, which simplifies the calculation. NOI is the numerator in the cap rate formula, so verifying it is the most important step in underwriting.
They move together. When borrowing costs rise, buyers require higher returns and cap rates tend to rise, which pushes values down. When rates ease, cap rates tend to compress and values rise. Industry forecasts pointed to modest compression of roughly 5 to 15 basis points across several property types in 2026 as rates stabilized.
A cap rate measures the unleveraged yield, the return as if you paid all cash. Cash-on-cash return measures the return on the actual cash you invested after financing, dividing your annual pre-tax cash flow by your down payment and closing costs. When the loan rate is below the cap rate you have positive leverage and cash-on-cash exceeds the cap rate. When it is above, leverage works against you.
Ready to evaluate a commercial investment in Sacramento?
Understanding cap rates is the starting point. Applying them correctly to a specific property, market, tenant, and lease structure is the real work. Matt Bingaman helps investors underwrite accurately and avoid the mistakes that look obvious in hindsight.