Cap Rate Explanation in Commercial Real Estate

Cap rates serve as an expression of expected return in commercial real estate, helping to evaluate property value based on income generation. For instance, a property purchased for one million dollars that yields a hundred thousand dollars in income reflects a 10% cap rate, while the same property generating fifty thousand dollars yields a 5% cap rate. The relationship between cap rates and property values is inverse: as cap rates decline, property values increase, and vice versa. This means that rising cap rates indicate falling property values, which some investors mistakenly interpret as positive. Essentially, cap rates act as multipliers showing property worth according to its revenue, with declining cap rates indicating an increase in property value for owners, while buyers benefit from rising cap rates that signify higher returns.