By Cole Borror · Director of Acquisitions, Sierra Capital Club · Reviewed September 2026
The short answer: A cap rate is net operating income divided by price. It is a one-period, unlevered pricing ratio that tells you what the market is paying for a property's current income. It is not your return, because it ignores financing, rent growth, capital costs, sale proceeds, and time. Yield on cost, cash-on-cash, and IRR each answer a different question.
In this article
- The number everyone quotes and almost nobody defines
- What a cap rate actually measures
- NOI quality: the numerator is the first problem
- Cap rate vs. yield on cost vs. cash-on-cash vs. IRR
- How a 6.5% cap deal beats a 7.5% cap deal
- Stress the exit, not just the hero case
- Rent bumps: growth, inflation protection, or catch-up?
- Residual value is where the spread can lie
- A better way to read every offering memorandum
- FAQ
The Number Everyone Quotes and Almost Nobody Defines
Two deals, same cap rate, and one of them is worth 20% more.
Picture two $2,000,000 properties. Each shows $140,000 of net operating income, so each is a 7.0% going-in cap. One has 2% annual rent bumps and sits on a corner that will lease to somebody else if the tenant leaves. The other has flat rent for fifteen years and a building nobody else wants. Same cap rate. Not remotely the same investment.
That is the whole problem with cap rate in one paragraph. It compresses today's income and today's price into one number, which is exactly why it is useful for screening and exactly why it is dangerous as a conclusion. It answers one question: what am I paying for this year's income? It cannot answer the other three that determine what you actually earn. What will the income become? How does debt change what reaches my equity? What will I get when I sell?
What a Cap Rate Actually Measures
The formula is simple:
Going-in cap rate = Year 1 (or stabilized) NOI ÷ purchase price
Flip it and you get the pricing function the market actually uses:
Value = NOI ÷ market cap rate
A 6% cap is a 16.67x multiple on NOI. An 8% cap is 12.5x. That is the sharper mental model: buyers are bidding a multiple for a specific income stream, and the multiple moves with credit, lease term, rent growth, location, liquidity, and how much residual risk they think they are taking. The Appraisal Institute's direct capitalization framework treats it exactly this way, as a ratio between one year's income and value, distinct from the yield capitalization methods that discount a full stream of cash flows.
Two properties of the ratio matter most. It is unlevered, because NOI is measured before debt service, so the cap rate is the same whether you pay cash or borrow 70%. And it is one period. Call it an initial unlevered income yield if you like, as long as you say which year's NOI you mean. Do not call it the realized return.
NOI Quality: The Numerator Is the First Problem
Everyone worries about whether the cap rate is right. Fewer people ask whether the NOI is right, and that is where the precision usually breaks first.
Start by naming the period. Trailing twelve months, current annualized, Year 1 forward, and "stabilized" are four different numbers, and an offering memorandum will use whichever is highest. Then look at what is inside it. Free rent that burns off. Reimbursements that assume every expense is recoverable. A property tax line that has not been reassessed at your purchase price. No reserve for roof, HVAC, or parking. Landlord capital obligations that the lease quietly leaves in place (the NNN lease explainer covers how often that happens). Rent that is above market, which is income you cannot count on past the current term.
A quick illustration. A $2,000,000 property is marketed at $140,000 of NOI, a 7.0% cap. Rebuild the NOI with a realistic tax reassessment, a modest capital reserve, and market-level management, and it drops to $125,000. Same price, and now it is a 6.25% cap. Nothing about the property changed. The number just got honest.
Cap rate precision is false precision if the NOI is soft. Rebuild the numerator before you argue about the denominator.
Cap Rate vs. Yield on Cost vs. Cash-on-Cash vs. IRR
Each of these answers a different question. None is "the best." The mistake is asking one of them a question it was not built for.
| Metric | Basic formula | Question it answers | What it leaves out |
|---|---|---|---|
| Going-in cap rate | Initial NOI ÷ purchase price | What is the market charging for today's income? | Future cash flows, debt, sale proceeds, timing |
| Yield on cost | Stabilized NOI ÷ total project cost (price plus improvements) | What does my all-in basis produce once stabilized? | Timing to stabilization, leverage, terminal value |
| Cash-on-cash return | Pre-tax cash flow after debt service ÷ equity invested | What is my equity earning in cash this year? | Appreciation, principal paydown, full-hold timing |
| IRR | Discount rate at which all modeled cash flows net to zero | What annualized result do my assumptions produce over the hold? | Risk; it is only as good as the assumptions feeding it |
Two clarifications that save people from bad comparisons.
Cash-on-cash moves with leverage even when nothing about the property changes. A 7% cap deal bought all-cash yields 7% cash-on-cash. The same deal with 65% debt at a 6.5% rate on a 25-year amortization yields roughly 5.0% on the equity, because the loan constant (about 8.1%) is above the cap rate. Positive leverage only exists when the cap rate exceeds the loan constant, and in the current rate environment that is often not the case.
Yield on cost is the development and value-add metric, and it is the number that answers "is this basis good?" The CFA Institute's real estate valuation material frames the whole discipline this way: a going-in cap rate prices what exists, while a yield-based measure prices what you are creating. The spread between yield on cost and the exit cap rate is where development profit lives.
How a 6.5% Cap Deal Beats a 7.5% Cap Deal
Here is the hook made concrete. All figures are hypothetical and every assumption is on the table.
| Assumption | Deal A | Deal B |
|---|---|---|
| Purchase price | $2,000,000 | $2,000,000 |
| Initial NOI | $130,000 | $150,000 |
| Going-in cap rate | 6.5% | 7.5% |
| Annual NOI growth | 2.0% | 0.0% |
| Year 11 NOI (used for exit) | $158,469 | $150,000 |
| Exit cap rate (Year 10 sale) | 7.0% | 8.0% |
| Gross sale price | $2,263,847 | $1,875,000 |
| Ten-year unlevered IRR | 7.94% | 7.05% |
Notice what is deliberately fair here. Both exit caps expand by 50 basis points from going-in, so there is no hidden assumption that the lower-cap deal gets rescued by cap rate compression. Deal A starts with a smaller check and compounds. Deal B starts with a bigger check, stands still, and sells at a lower multiple because flat-rent, shorter-remaining-term assets trade wider.
This is not a proof that growth always wins. Change one assumption and it flips. It is a demonstration that a going-in cap rate cannot answer a multi-period question, because the answer lives in the rows the cap rate does not contain.
Stress the Exit, Not Just the Hero Case
One base case is a sales pitch. Three cases are underwriting. Using the same two deals:
| Scenario | Deal A unlevered IRR | Deal B unlevered IRR |
|---|---|---|
| Base case (above) | 7.94% | 7.05% |
| Base case with 2% selling costs | 7.79% | 6.91% |
| Deal A rent goes flat (no growth) | 5.96% | 7.05% |
| Exit caps expand 100 bps instead of 50 | 6.97% | 6.25% |
Two things jump out. First, if Deal A's rent growth does not show up, it loses, and loses by more than it won. The lower-cap deal only wins where the growth assumption is real. Second, in every scenario a large share of the modeled return arrives on the sale date. In the base case, Deal A's resale is roughly $2.26 million against $1.42 million of cumulative NOI over ten years. When more than half of your return is resale, you are underwriting the exit cap whether you admit it or not.
Rent Bumps: Growth, Inflation Protection, or Just Catch-Up?
Contractual escalations are where the "growth" in Deal A comes from, so they deserve a harder look than the flyer gives them.
Timing matters. A 10% bump every five years and 2% annually sound similar but are not; the annual structure compounds sooner and reaches a higher Year 11 NOI. CPI-linked bumps with caps and floors behave differently again in an inflationary year than a flat one.
More important is where contractual rent sits relative to market rent at rollover. A 2% bump is valuable when it keeps rent aligned with the market and the tenant's store economics can carry it. It becomes a liability when it pushes rent above what the location supports, because the tenant that owes higher rent is not the tenant that renews. Contractual growth and economic growth are different things. A tenant can be obligated to pay more every year while the property's releasing value quietly falls.
And in net lease specifically, stated rent is not always NOI. Roof, structure, capital items, administration, vacancy, and releasing costs can all sit outside the clean marketing number, which sends you back to reading the lease, not the label.
Residual Value Is Where the Spread Can Lie
Terminal value in most models is forward NOI divided by an assumed exit cap. Small changes in either input dominate the modeled return, which is why the exit deserves as much underwriting as the entry.
Underwrite what remains when the current lease is gone: market rent for the space, the pool of alternative users, parcel size, access, zoning, how adaptable the building is, replacement cost, and realistic downtime. A high going-in cap is frequently compensation for short remaining term, above-market rent, weak credit, a specialized building, or a shrinking buyer pool. A low cap can reflect durable credit and real estate, or it can reflect overconfidence. The corporate vs. franchisee guaranty question and the residual real estate question together explain most of the cap rate spread you see between two properties with the same sign on the front.
Now the 20% from the opening. Two assets both start at $140,000 of NOI. Discount ten years of cash flow plus a terminal value at 8%. The first grows NOI 2% a year and exits at a 6.5% cap: about $2,232,000 of modeled value. The second is flat and exits at a 7.1% cap: about $1,853,000. That is a 20.5% difference between two properties that both show as "7% caps" on the offering memorandum. The result is entirely assumption-driven, which is the point. The assumptions are where the value is, and the cap rate hides them.
A Better Way to Read Every Offering Memorandum
- Rebuild NOI from the lease and the actual expense obligations, not the broker's pro forma.
- Name the period: trailing, current, Year 1, forward, or stabilized.
- Chart every contractual rent change and every option period on a timeline.
- Model unlevered cash flows first, before you pick a loan.
- Layer in debt to get cash-on-cash and levered IRR, and check whether leverage is positive or negative at today's loan constant.
- Stress rent growth, downtime, capital costs, selling costs, and the exit cap. Run at least three cases.
- Compare contractual rent to market rent, and the building to its likely next use.
- Decide, in one sentence, which risk the extra cap rate spread is paying you to take.
The place I see step eight skipped most is on the "high cap" deal. A 7.5% cap on a 15-year lease sounds like a bargain until you write down why it is trading there and the answer is that the rent is 20% over market and the building is a purpose-built box. The spread is not a gift. It is a price for a risk, and the exercise is naming the risk before you accept the price.
Use the Snapshot, Buy the Movie
Cap rate remains an excellent screening and pricing tool. It strips out financing, it lets you compare two properties in a second, and it tells you what the market is charging for a dollar of current income. It answers a narrow question well. Do not force it to answer the full-hold return question, because it cannot.
Cap rate tells you what today's income costs. Yield on cost tells you what your basis produces. Cash-on-cash tells you what reaches your equity now. IRR tells you what your assumptions produce over time. Know which question you are asking before you trust the answer.
Where the cap rate spread comes from is the subject of the next two reads: who is actually promising to pay the rent, and, for operators on the other side of the table, how sale-leaseback rent sets the price of the real estate they are selling. For a sector where all four metrics collide, see how to underwrite a c-store.
Frequently Asked Questions
Is cap rate the same as ROI? No. Cap rate is one year's NOI divided by price, before debt and before any sale. ROI or total return includes financing, cash flows over the whole hold, and sale proceeds. A property can have a 7% cap rate and produce a 4% or 12% total return depending on leverage, growth, and exit.
Does cap rate include the mortgage? No. NOI is calculated before debt service, so cap rate is an unlevered measure. Financing shows up in cash-on-cash return and levered IRR, not in the cap rate.
Is a higher cap rate always better? No. A higher cap rate means a lower price for current income, which usually reflects more perceived risk: shorter term, weaker credit, above-market rent, or a harder-to-release building. It is only "better" if the extra yield exceeds the extra risk.
Do contractual rent increases raise the going-in cap rate? Not by themselves. Going-in cap uses Year 1 NOI. Future escalations affect later-year yield on original cost, the exit value, and the IRR, but the going-in cap rate stays the same. Buyers may pay a lower going-in cap for a lease with strong bumps, which is the market pricing that growth in advance.
What is a good cap rate? There is no universal answer. A "good" cap rate is one that fairly compensates you for the specific credit, lease term, rent growth, residual, and financing risks of that property relative to the alternatives. As a reference point, The Boulder Group's Q2 2026 net lease report put the median national asking cap rate for single-tenant retail at 6.60%, with corporate QSR at 5.85% and franchisee QSR at 6.85%. Those are asking rates across broad categories, not a target for any one deal.
Related reading in this series
- What a NNN lease actually is, and the different kinds of commercial leases
- Corporate guaranty vs. franchisee guaranty: what you're actually buying
- Estoppels and SNDAs in plain English
- Nine ways a net lease deal actually gets done
- Sale-leasebacks from the operator's side of the table
- PropCo/OpCo separation: an operator's guide
- The 1031 exchange timeline that kills deals
- How to underwrite a c-store net lease
About the author. Cole Borror is Director of Acquisitions at Sierra Capital Club, a Dallas-based net lease investment and development firm. He works on NNN and NN acquisitions, build-to-suit development, sale-leasebacks, and operator partnerships. Connect at coleborror.com.
This article is for educational purposes only and is not investment, tax, or legal advice. All examples are hypothetical, all rates are illustrative, and modeled returns are not predictions. Consult qualified advisers before making investment decisions.