Cap Rates in Motion: Understanding Value Beyond the Formula

Introduction

My first experience in real estate was in the business development arm of a property management company, overseeing a portfolio of around 160 single-family homes. It was a lean, hands-on team where everyone was directly involved in operations—tenant relations, expense optimization, and ensuring properties performed while owners received their distributions. Stepping into multifamily real estate as a principal required a shift in perspective.

Managing properties was one thing, understanding how they were valued in the market was another. Instead of focusing on day-to-day operations, I had to think like an investor, seeing properties as vehicles for returns, risk, and capital allocation. The numbers that mattered weren’t just revenue and expenses, but how the market priced income-producing assets. That’s where cap rates entered the conversation not as the formula we all know, but as a lens for understanding value.

The goal of this article is to take a deeper dive into capitalization rates. Not just as a formula, but as a fundamental tool for valuation. We’ll explore how cap rates reflect market sentiment, risk, and capital flows, and why understanding their movement is critical to making sound investment decisions in CRE.

Why valuation is the foundation of Real Estate

If I had to distill everything I’ve learned in real estate and finance into a single principle, it would be this: Nearly every asset makes financial sense at the right price.

In my experience, mistakes, headaches, and financial losses in real estate rarely come from bad operations, poor tenant management, or even macroeconomic shifts. They almost always come from overpaying for an asset on day one. You can fix management inefficiencies, reposition a property, and even ride out a downturn, but if you buy at the wrong price, you’re fighting an uphill battle from the moment pen meets paper.

That’s why valuation is the most important step in acquisitions. Before thinking about financing, operations, or exit strategies, the most fundamental question is:

What is this property actually worth?

That question was top of mind when I was on the phone with a broker pitching me a 12-unit deal for $2.6M, later dropping to $2.45M, in a 6% cap market. The property was in rough shape, but he claimed rents could reach $2,000 per unit per month after renovations, an aggressive target even with heavy investment. Of course, a broker’s job is to sell the deal’s potential, but my job is to test whether the numbers hold up.

For value-add acquisitions like this, we price based on stabilized NOI, not the in-place cap rate. I pulled rent comps from similar properties in the area and found that even after renovations, $1,750/unit was a more realistic assumption. Running the numbers, the deal still didn’t pencil.

Assuming a 40% expense ratio, the broker’s pro forma $2,000 rents would produce $172,800 NOI, implying a $2.88M valuation. But adjusting for actual market rents of $1,750 per unit, NOI dropped to $151,200, bringing the fair value down to $2.52M.

Even at the broker’s "discounted" $2.45M, the numbers were still stretched. With $300K–$360K in CapEx, my all-in basis would hit $2.75M+, leaving little room to justify this deal to those trusting us to deploy their capital wisely.

This is why understanding cap rates in your market is critical. They provided the framework to evaluate the deal objectively, cut through inflated projections, and see it for what it was: overpriced and misaligned with our current strategy.

What cap rates represent and what drives them

At its core, the cap rate formula is fundamental in CRE: Cap rate = NOI / purchase price. The beauty of algebra is that this formula can be rearranged to solve for any of the three variables that make it up.

Beyond the formula, cap rates function as a pricing mechanism, reflecting the interplay between risk, investor demand, and available capital. A cap rate represents the relationship between a property's income and its price, incorporating market expectations about risk, growth, and future cash flows.

For example, take two identical apartment buildings, each generating $500K in NOI. One trades at a 4.5% cap in a major metro, while the other trades at a 7% cap in a secondary market.

The lower-cap asset commands a premium due to higher investor demand, stability, and potential appreciation, pricing it at $11.1M, while the higher-cap deal is valued at $7.1M.

The difference isn’t in the asset itself but in how the market prices risk, investor demand, and long-term growth potential. A lower cap rate often signals stronger tenant demand, institutional interest, and better financing options, while a higher cap rate compensates investors for risk, weaker liquidity, or operational challenges.

Lower cap rates reflect investor confidence, access to capital, and expectations of future income growth, while higher cap rates signal perceived risk or weaker demand. Unlike IRR, which accounts for financing and time, cap rates provide a snapshot of value at a given moment, making them a powerful but incomplete metric on their own.

While cap rates offer a useful benchmark, they adjust over time in response to macroeconomic conditions, investor sentiment, and capital markets. When these forces change, cap rates adjust with them, influencing how real estate assets are priced.

Interest Rates

One of the most well-known influences on cap rates is interest rates. Since real estate competes with other asset classes for capital, changes in borrowing costs and risk-free returns directly impact pricing. When interest rates rise, the cost of debt increases, often putting upward pressure on cap rates as investors demand higher returns. Conversely, when rates fall, cap rates tend to compress as capital flows into real estate in search of yield.

However, the relationship between cap rates and interest rates is not a simple one-to-one correlation. The spread between cap rates and risk-free rates, such as the 10-Year Treasury, is often more critical than the absolute level of interest rates. There have been cycles where rates increased, yet cap rates remained stable or even compressed because investors anticipated strong rent growth or had alternative capital sources to offset higher borrowing costs.

Between 2004 and 2006, the Federal Reserve raised interest rates from 1% to 5.25%, yet cap rates across many asset classes remained compressed due to abundant liquidity and aggressive underwriting. Similarly, during the 2015 to 2019 rate hike cycle, cap rates in major metros held firm as investors underwrote strong rent growth assumptions, keeping valuations elevated despite rising borrowing costs. While rising interest rates typically put upward pressure on cap rates, strong market fundamentals can offset this effect.

Market segmentation also plays a role. A prime asset in a major metro with institutional-grade tenants may see little cap rate movement during rate hikes, as long-term investors prioritize stability over short-term financing costs. Meanwhile, a value-add property in a secondary market might experience sharper cap rate expansion as lending conditions tighten and return expectations shift.

While interest rates influence cap rates, they do not dictate them.

Investor Demand and Liquidity

Another main driver of cap rates is investor demand and liquidity. Cap rates ultimately reflect how much capital is competing for income-producing assets, which is shaped by the availability of financing and investor risk appetite.

When liquidity is abundant, capital seeks yield, often compressing cap rates even in higher-rate environments. Institutional capital, foreign investment, and REIT activity can all drive cap rates lower as demand increases for a limited supply of assets. Conversely, when capital markets tighten, risk premiums expand, and investors become more selective, pushing cap rates higher.

Periods of strong investor demand have historically kept cap rates low despite rate hikes, as seen in 2015 to 2019, when sustained capital inflows and rent growth expectations countered rising borrowing costs.

On the other hand, during liquidity crises, such as the 2008 financial downturn, cap rates expanded sharply as financing dried up and risk tolerance fell.

While investor sentiment and liquidity conditions fluctuate, they remain among the most powerful forces behind cap rate movement.

Where investors might misuse cap rates

By applying what we have covered in this article, we can identify common ways cap rates are misused and understand why they can be misleading when taken at face value.

A frequent mistake is treating cap rates as a fixed measure of value rather than a reflection of market conditions. Cap rates shift with changes in capital markets, risk sentiment, and liquidity. Assuming they will remain static or move predictably can lead to flawed underwriting, especially when investors rely on cap rate compression to justify projected returns rather than focusing on fundamentals like NOI growth and asset improvements.

Misapplying market cap rates is another common issue. Not all properties in the same market should trade at the same cap rate, yet some investors fail to account for differences in risk, asset quality, and long-term income potential. A well-located, stabilized asset commands a different risk profile than a value-add deal requiring heavy repositioning. Similarly, two properties with identical in-place cap rates may have drastically different return profiles depending on tenant credit, lease structure, and capital requirements. Focusing on cap rates in isolation, without analyzing rent growth, capital expenditures, and financing structure, can lead to mispriced deals and unrealistic expectations.

Cap rates provide a useful benchmark for pricing and return expectations, but they are not a substitute for a full underwriting process. Investors who rely too heavily on them without considering the broader financial picture risk mispricing assets and misjudging market conditions.

?Final thoughts

Writing this piece has been an exercise in breaking down a concept that is both fundamental and widely misunderstood. Cap rates are simple in form yet complex in application, shaped by a web of macroeconomic forces, investor psychology, and market dynamics. While I’ve aimed to present a clear and structured framework for understanding them, the reality is that no single article can capture the full depth of how cap rates interact with the broader real estate landscape.

One of the biggest challenges in writing about cap rates is balancing precision with practicality. Every market cycle, asset class, and investment thesis introduces nuances that resist blanket statements. The examples I’ve used are meant to illustrate broad principles, but in practice, each deal requires its own analysis. Cap rates do not exist in isolation, and their behavior is deeply tied to capital markets, risk pricing, and investor sentiment, all of which are constantly evolving.

As I become more active in writing, I look forward to refining these ideas, exploring deeper layers of market analysis, and engaging with others who think critically about real estate investing. My goal is not just to write, but to write with clarity and purpose—to challenge assumptions, sharpen my own thinking, and contribute meaningful insights to an industry that thrives on experience and shared knowledge.

There is always more to discuss, more to refine, and more to learn. If you’ve made it this far, I appreciate your time and your willingness to engage with these ideas. This is just the start, and I look forward to continuing the conversation.

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Thank you to Justin Kivel, Robert Rixer, Alexander D’Souza, and Spencer Burton for inspiring the idea for this article. Writing was edited with the help of the ChatGPT-4o model, all thoughts are my own.