If you spend any time around commercial real estate investors, you'll hear "cap rate" within the first five minutes. It's the single most common shorthand for property valuation in commercial real estate — a quick way to compare properties, estimate value, and assess risk. Understanding it is essential to any commercial investment conversation.
The basic formula
Capitalization rate (cap rate) is calculated as:
Cap Rate = Net Operating Income (NOI) ÷ Property Value Or rearranged to solve for value: Property Value = NOI ÷ Cap Rate
NOI is the annual income the property generates after operating expenses (taxes, insurance, management, maintenance) but before debt service and income taxes. It does not include capital expenditures, which are a separate consideration.
What cap rates look like in Chicagoland
Cap rates vary by property type, location, tenant credit, and lease term. In the current Chicagoland market:
- Net-leased industrial (strong tenant, long term): 5.5–6.5%
- Multi-tenant industrial: 6.0–7.5%
- Net-leased retail (national credit, long term): 5.5–6.5%
- Multi-tenant retail strip centers: 7.0–9.0%
- Suburban office: 7.5–10.0%+ (elevated due to market uncertainty)
- Class A suburban office (long-term, creditworthy tenant): 6.5–7.5%
As a general rule, lower cap rates indicate lower perceived risk and higher asset quality — and therefore higher prices per dollar of income. A 5.5% cap rate for a single-tenant industrial property with a 10-year lease to a Fortune 500 company reflects the low risk of that income stream.
Cap rate and financing
Cap rate takes on special significance when compared to borrowing costs. If you can borrow at 6% and the property yields a 7.5% cap rate, you have positive leverage — your return on equity is amplified by the debt. If borrowing costs rise above the cap rate, you have negative leverage, which compresses your equity returns.
Rising interest rates in recent years have compressed the spread between cap rates and financing costs, making some commercial investments less attractive on a leveraged basis than they appeared at lower rates. This is one reason transaction volume slowed and some investors pivoted to all-cash acquisitions.
Where cap rate falls short
Cap rate is a snapshot, not a projection. It tells you what the property yields today, not what it will yield in 5 or 10 years. A property with below-market in-place leases may have a low cap rate today but significant upside when leases roll. A property with above-market leases may look attractive on cap rate today but face rent reduction at renewal.
Cap rate also does not account for capital expenditures. A building with a 20-year-old roof generating a 7.5% cap rate might be a worse investment than one yielding 6.5% with a new roof and updated systems. Always underwrite CapEx alongside cap rate.
