Cap Rate
In simple terms, the cap rate, short for capitalization rate, is a measure used to evaluate the potential return on investment (ROI) of a property.
Understanding Cap Rate
Capitalization rate (cap rate) is the most widely used metric in commercial real estate valuation. It expresses the relationship between a property's net operating income and its market value as a percentage. Cap rate serves as both a valuation tool and a shorthand for investment risk—lower cap rates indicate lower perceived risk (and higher prices), while higher cap rates signal higher risk (and lower prices).
The cap rate is calculated by dividing a property's NOI by its purchase price or current market value. A property generating $100,000 in NOI purchased for $1,666,667 represents a 6.0% cap rate. This metric allows investors to quickly compare properties across markets, tenant types, and asset classes on an apples-to-apples basis.
In the NNN sector, cap rates vary significantly based on tenant credit quality, remaining lease term, rent escalation structure, and property location. Investment-grade single-tenant NNN properties (McDonald's, Walgreens, Dollar General) typically trade at 5.0-6.5% cap rates, while non-investment-grade tenants trade at 7.0-9.0%+. Each 25 basis point change in cap rate represents a significant change in property value.
Cap rate movements are influenced by interest rates, investor demand, market conditions, and economic outlook. The spread between cap rates and Treasury yields (or borrowing costs) determines leverage attractiveness. When cap rates exceed borrowing costs, positive leverage exists, enhancing equity returns. Understanding cap rate dynamics is arguably the most important skill for NNN investors.
Why Cap Rate Matters to Investors
Cap rate is the primary language of NNN investment pricing. Every acquisition decision ultimately centers on whether the cap rate adequately compensates for the property's risk profile. Investors must understand that a low cap rate doesn't always mean a bad deal—a 5.25% cap on a Chick-fil-A with 15 years remaining may offer better risk-adjusted returns than a 7.5% cap on a local restaurant with 3 years left. The cap rate spread over borrowing costs determines whether leverage enhances or dilutes your equity returns, making this metric inseparable from financing analysis.
Related CRE Concepts
Net Operating Income (NOI)
Net operating income (NOI) is the most widely used performance metric in commercial real e...
Cap Rate Compression
Cap rate compression occurs when capitalization rates decrease over time, typically driven...
Net Lease Cap Rates
As a commercial property owner, understanding net lease cap rates is essential to maximizi...
Spread (Cap Rate Spread)
The cap rate spread is the difference between NNN cap rates and a benchmark risk-free rate...
Positive Leverage
Positive leverage occurs when the return on the total property investment (cap rate) excee...
Yield
Yield refers to the return on an investment, typically expressed as a percentage, that is ...
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Frequently Asked Questions
What is a good cap rate for NNN properties in 2025-2026?
NNN cap rates in 2025-2026 typically range from 5.0% to 8.0%+ depending on tenant credit quality and lease terms. Investment-grade tenants like McDonald's and Chick-fil-A trade at 5.0-5.75%. National retailers like Dollar General and AutoZone trade at 6.0-7.0%. Non-investment-grade local tenants typically trade at 7.5-9.0%+. Cap rates have been influenced by elevated interest rates keeping the 10-year Treasury above 4%.
How does cap rate relate to property value?
Cap rate and property value have an inverse relationship. When cap rates decrease (compress), property values increase for the same NOI. When cap rates increase (expand), values decrease. A 50 basis point cap rate change on a $150,000 NOI property means roughly a $400,000-500,000 change in value, illustrating why even small cap rate movements have significant financial impact.
What is the difference between going-in and exit cap rates?
Going-in cap rate is the cap rate at the time of purchase (NOI ÷ purchase price). Exit cap rate is the assumed cap rate at the time of future sale, used in discounted cash flow analysis. Investors typically assume exit cap rates 50-100 basis points higher than going-in rates to be conservative, accounting for lease term deterioration and market uncertainty.
Why do cap rates vary between NNN tenant types?
Cap rates reflect risk—lower rates indicate lower perceived risk. Investment-grade tenants (McDonald's, Walmart) trade at lower cap rates because of strong credit, essential business models, and lower default probability. Non-investment-grade tenants trade at higher cap rates to compensate investors for greater credit risk, shorter lease terms, and higher potential vacancy. Location, lease structure, and remaining term further differentiate cap rates within tenant categories.