What a Cap Rate Actually Is

A capitalization rate is net operating income divided by purchase price. A property generating $100,000 in NOI bought for $1.25 million trades at an 8% cap. Cap rate is a snapshot of yield, not a return. Two properties at identical cap rates can produce very different total returns once leverage, vacancy, and capital expenditure are layered in.

What Cap Rates Reflect

Cap rates are priced by three forces: prevailing risk-free interest rates, the perceived risk of the asset, and the expected growth in NOI. When the 10-year Treasury moves, commercial cap rates move with it on a lag of six to eighteen months. Investors targeting yield in a rising-rate environment must underwrite to where cap rates will be at exit, not where they sit at closing.

Net Operating Income, Cleanly Defined

NOI is gross rental income, less vacancy, less operating expenses, before debt service and before income tax. The mistake most novice investors make is omitting reserves for replacement, management fees, and tenant improvement allowances. A "stabilized" NOI that ignores a $80,000 roof in year five is fiction.

Debt Service Coverage Ratio

DSCR is NOI divided by annual debt service. Lenders want 1.20 to 1.35 minimum on most commercial loans. A 1.20 DSCR means the property generates $1.20 of NOI for every $1.00 of mortgage payment. Tight DSCR leaves no margin for vacancy, expense increases, or rate resets at refinance.

The Five Property Types and Their Risk Profiles

• Multifamily — most liquid, lowest cap rates, deepest financing market. Tenant rollover is constant but small.
• Industrial — long leases, single-tenant exposure, high re-tenanting cost when a tenant leaves.
• Office — most volatile post-pandemic, longest down-leasing periods, highest tenant improvement cost.
• Retail — anchor-tenant risk, co-tenancy clauses, e-commerce headwinds in most subtypes.
• Hospitality — daily repricing, operationally intensive, highest correlation with macro cycles.

Leverage Cuts Both Ways

A 65% loan-to-value mortgage at a 6.5% interest rate against a 7.5% cap-rate asset produces positive leverage — your cash-on-cash return rises above the unlevered yield. The same leverage against a 6% cap-rate asset at a 6.5% rate produces negative leverage. Investors who chased low cap rates with high leverage in the 2021-2022 cycle wrote large checks when rate resets came.

The Exit Assumption Is the Whole Deal

Most commercial returns are made or lost at sale, not at the rent roll. Underwrite the exit at a cap rate 50 to 75 basis points higher than purchase. If the deal still hits target IRR with cap rate expansion and modest NOI growth, the underwriting is honest. If it only works at flat or compressing cap rates, the underwriting is a prayer.

What Risk Actually Looks Like

The real risks in commercial real estate are tenant default, refinance risk, capital call exposure in syndications, and illiquidity. A bad office tenant can take 24 months and $200 per square foot in tenant improvements to replace. A loan maturing into a higher-rate environment can force a cash-in refinance or a forced sale. These are the scenarios that get stress-tested before close, not after.