Capitalization Rate

The capitalization rate (cap rate) is a real estate valuation metric that divides a property's net operating income (NOI) by its current market value or sale price — expressing the rate of return a property generates based on income it's expected to produce. In M&A contexts, cap rates arise most directly when acquisitions involve commercial real estate or when operating businesses are valued using an income capitalization approach rather than a revenue multiple.

The formula and its logic: Cap Rate = Net Operating Income / Property Value. Equivalently, Property Value = NOI / Cap Rate. If a commercial building generates $200K in NOI and trades at a 5% cap rate, its value is $4M ($200K / 0.05). The cap rate is the inverse of a price-to-earnings ratio in equities — a lower cap rate means a higher valuation relative to income, just as a higher P/E means a higher valuation relative to earnings. Cap rates compress in low-interest-rate environments (properties are more expensive) and expand when rates rise (properties are cheaper relative to income).

Cap rates in business acquisitions: When an operating business owns real estate, the acquisition may involve valuing the real estate separately (using a cap rate) and the operating business separately (using an EBITDA multiple). Alternatively, if the real estate is leased and the buyer is doing a sale-leaseback, the cap rate determines how much the real estate can be sold for. Industrial properties typically trade at 5–7% cap rates, retail varies widely (5–9%), office at 6–9%, and single-tenant net lease properties at 4–6% in recent markets.

Cap rate vs. EBITDA multiple in business valuation: For small businesses, the income capitalization approach applies an earnings multiple (EBITDA multiple) rather than a cap rate — but the conceptual framework is identical. An EBITDA multiple of 5x is equivalent to a 20% capitalization rate; a multiple of 10x is equivalent to a 10% cap rate. The cap rate framework is simply the real estate convention for expressing the same income-to-value relationship used in business valuation.

Factors that drive cap rates: Cap rates reflect risk — riskier properties trade at higher cap rates (lower prices). Key risk factors include: location quality, tenant credit quality, lease term remaining, property condition, local economic conditions, and prevailing interest rates. Cap rates track (though don't perfectly match) risk-free interest rates — as the 10-year Treasury rises, cap rates tend to rise, compressing real estate values.