2.2 Cap Rates and Property Valuation
A cap rate is a property’s yearly net income divided by its value, so value equals income divided by the cap rate. It works like a yield. The cap rate equals the required return minus the growth rate of income. So when interest rates rise, cap rates tend to rise too, and property values fall, even though the rent hasn’t changed.
Why it matters: A building can lose value without any tenant leaving.
Summary: A cap rate is net operating income divided by value, so value = NOI ÷ cap rate. Because the cap rate equals the required return minus NOI growth (r − g), cap rates rise when interest rates rise and property values fall, even when rent is unchanged.
- NOI is rent after vacancy and operating costs, before debt service, depreciation and income tax.
- At a 6.5% cap rate, a one-point rise in the cap rate cuts value by 13.3%.
- Rents that grow with inflation cushion a rate rise; tightening credit makes it worse (−3.7% vs −23.5% in the scenarios).
- Buying at 5.5% and selling at 7.0% loses 21.4% of value and 71% of equity at 70% leverage.
Commercial real estate’s standard valuation shorthand is the capitalization rate (cap rate) — a property’s annual net operating income (NOI, rental income minus operating expenses, before financing costs) divided by its value. Rearranged, a property’s value equals its NOI divided by the market’s prevailing cap rate for similar properties — directly analogous to the comparable company multiples from The Practitioner’s Codex Part 1, but applied to buildings instead of companies.
Value = NOI ÷ Cap Rate
Step 1, build the NOI (an office building, annual): potential gross rent $13.50M − vacancy and credit loss at 8% ($1.08M) + other income such as parking ($0.30M) = effective gross income of $12.72M; − operating expenses such as property tax, insurance, utilities, repairs and management ($4.48M) − replacement reserve ($0.24M) = NOI of $8.00M. NOI excludes debt service, depreciation and income tax: it describes the building, not the owner. Conventions differ on whether reserves sit above the NOI line, so check before comparing cap rates.
Step 2, value it. At a 6.5% cap rate, value = $8.00M ÷ 0.065 ≈ $123.1M. If the cap rate compresses to 5.5% (lower interest rates or stronger demand), value = $8.00M ÷ 0.055 ≈ $145.5M (+18.2%); if it expands to 7.5%, value = $8.00M ÷ 0.075 ≈ $106.7M (−13.3%). Rent is identical in all three.
Cap rates usually move in the same direction as interest rates: when rates rise, buyers demand a higher income yield, the cap rate rises, and because value = NOI ÷ cap rate, property values fall even though rent has not changed. That is the bond relationship exactly, yield up and price down (The Practitioner’s Codex Part 3): the cap rate is the yield, and the property’s price is what moves against rates. Real estate behaves as a long-duration asset; at a 6.5% cap rate, a one-point rise in the cap rate cuts value by 13.3%.
A cap rate is the Gordon Growth formula of a DCF terminal value (The Practitioner’s Codex §1.3) applied to a building. If NOI grows at g forever and investors require an unlevered return r, value = NOI ÷ (r − g), so cap rate = r − g. Here r is a risk-free rate plus a property risk premium, and g is long-run NOI growth after the capital spending needed to stay competitive (not the r and g of the government debt identity in Part 3.7: Debt Sustainability Analysis — r versus g). Worked, with illustrative inputs: 10-year Treasury yield 4.0% + property premium 4.5% = r of 8.5%; g = 2.0%; cap rate = 6.5%.
So cap rates move with rates, risk premiums and growth. Across 30 US metro areas over 1980–2007, the corporate risk premium and the supply of debt explained cap rates beyond Treasury yields (Chervachidze, Costello and Wheaton, 2009), which is why cap rates do not track Treasuries point-for-point.
Start from NOI $8.00M, r = 8.5%, g = 2.0%, cap rate 6.5%, value $123.1M.
| Scenario | r | g | Cap rate | Value | Change |
|---|---|---|---|---|---|
| A. Rates +1, growth unchanged (fixed-rent leases) | 9.5% | 2.0% | 7.5% | $106.7M | −13.3% |
| B. Rates +1, rents pass inflation through (g +0.75) | 9.5% | 2.75% | 6.75% | $118.5M | −3.7% |
| C. Rates +1, premium +0.5, growth −0.5 (credit tightens) | 10.0% | 1.5% | 8.5% | $94.1M | −23.5% |
Break-even: value is unchanged only if g rises one-for-one with r, so g must reach 3.0% to offset a one-point rate rise. Indexed leases get part of the way; fixed rents get none; tightening credit makes it worse.
When the link breaks. Three things loosen the tie between Treasury yields and cap rates. First, lag: a cap rate is observed only when a building sells, and owners facing lower bids tend to wait, so reported cap rates trail bond yields by quarters. Second, sentiment and credit supply: Chervachidze, Costello and Wheaton found a pessimistic period in 1991–1996 and an exuberant one in 2002–2007 that interest rates and fundamentals did not explain. Third, the spread over Treasuries can absorb part of a move. Here the cap rate sits 2.5 points above a 4.0% Treasury; if buyers accept a 2.0-point spread after yields rise to 5.0%, the cap rate rises only to 7.0% and value falls to $8.00M ÷ 0.07 = $114.3M (−7.1%) rather than −13.3%. Spreads that are already thin leave nothing to absorb, which is why the one-for-one move is the stress case to plan for, not the forecast.
Derive every cap rate twice, from comparable sales and as r − g. If the two differ by more than about half a point, find out why before relying on either. Underwrite the exit at or above the entry cap rate unless you can name the change in r or g that justifies a lower one. These are heuristics. For properties without stable NOI (lease-up, redevelopment), skip the cap rate and build an explicit DCF.
Buying at a cap rate compressed by low interest rates and assuming you will sell at the same rate. Buy the $8.00M-NOI building at 5.5% ($145.5M) and sell at 7.0% with NOI unchanged: $8.00M ÷ 0.07 = $114.3M, a $31.2M (21.4%) loss without losing a tenant. With a $101.8M loan (70%) outstanding, equity falls from $43.6M to $12.5M (−71%). Stress the exit cap rate at least one point above entry.
Do cap rates go up when interest rates rise?
Usually, yes. Higher rates raise the return investors require (r), so the cap rate (r − g) rises and values fall. The effect is weaker where rents grow with inflation and stronger when credit tightens too. Cap rates lag because they come from completed sales, and owners delay selling into a falling market.
How do you calculate NOI?
Take potential gross rent, subtract vacancy and credit loss, add other income to reach effective gross income, then subtract operating expenses such as property tax, insurance, utilities, repairs and management. Do not subtract mortgage payments, depreciation or income tax. In the worked example $13.50M of potential rent yields $8.00M of NOI.
Is the cap rate the same as my return?
No. The cap rate is a one-year income yield on an all-cash purchase. The total unlevered return is roughly the cap rate plus NOI growth, so a 6.5% cap rate with 2% growth implies about 8.5%. Leverage then raises or lowers the return to equity (Section 2.1: The Capital Stack — How Real Estate Deals Are Financed).
Value equals NOI ÷ cap rate, and the cap rate behaves like r − g, the required return minus NOI growth, so cap rates rise when interest rates rise and property values fall, just as bond yields rise when bond prices fall. Rent growth that tracks inflation cushions the fall, while tightening credit deepens it; underwrite the exit at or above the entry cap rate.
Four questions on this chapter. Decide on your answer first, then click “Reveal Answer.”
1. A building with $5.2M of NOI is valued at a 6.5% cap rate. If market cap rates rise to 8.0% and NOI is unchanged, what is it worth?
- $80.0M
- $84.5M
- $65.0M
- $74.3M
Reveal Answer
Answer: C. Value = NOI ÷ cap rate: $5.2M ÷ 0.08 = $65.0M, down 18.75% from $5.2M ÷ 0.065 = $80.0M.
2. Investors require a 9.0% unlevered return and expect NOI to grow 2.5% a year forever. What cap rate does this imply?
- 9.0%
- 6.5%
- 2.5%
- 11.5%
Reveal Answer
Answer: B. Cap rate = r − g = 9.0% − 2.5% = 6.5%, the Gordon Growth formula applied to a building.
3. Long-term interest rates rise by a point and a building’s rent is unchanged. What usually happens?
- Cap rates rise and property values fall
- Cap rates fall and property values rise
- Cap rates rise and property values rise
- Cap rates fall and property values fall
Reveal Answer
Answer: A. Higher rates raise the required return r, so the cap rate (r − g) rises and value = NOI ÷ cap rate falls.
4. Which of these is subtracted in calculating a property’s net operating income?
- The owner’s income tax
- Mortgage interest
- Depreciation
- Property taxes
Reveal Answer
Answer: D. NOI deducts the costs of running the building, such as property tax, but excludes financing, depreciation and the owner’s income tax.
2.3 REITs — Real Estate as a Public Market Asset
A REIT is a company that owns income-producing property and lets you buy a slice of it like a stock. It avoids US corporate tax by deducting the dividends it pays, as long as it distributes at least 90% of its taxable income and meets asset, income and ownership tests. Investors judge REITs on funds from operations, adjusted FFO and net asset value rather than on earnings.
Why it matters: REITs have their own scorecards, so earnings alone tell you little.
Summary: A REIT owns income-producing real estate and avoids US corporate tax by deducting the dividends it pays, provided it distributes at least 90% of its taxable income and passes asset, income and ownership tests. Investors value it on funds from operations (FFO), AFFO and net asset value rather than on earnings.
- FFO adds real estate depreciation back to net income and removes gains on property sales (Nareit definition).
- AFFO also subtracts recurring capital spending and has no standard definition.
- The §199A deduction, made permanent in 2025, cuts the top federal rate on ordinary REIT dividends to 29.6%.
- A REIT trading below NAV cannot issue shares to buy buildings without diluting its holders.
A Real Estate Investment Trust (REIT) is a company that owns, and typically operates, income-producing real estate, with its shares traded on a public stock exchange — letting ordinary investors gain exposure to commercial real estate without directly buying and managing a building themselves. In most jurisdictions, REITs receive a specific tax advantage (avoiding corporate-level tax) in exchange for a strict requirement to distribute the great majority of their taxable income — typically 90% or more — to shareholders as dividends every year.
A REIT deducts the dividends it pays, so distributed income is taxed once, by the shareholder. To qualify each year it must distribute at least 90% of REIT taxable income; hold at least 75% of assets in real estate, cash and government securities; earn at least 75% of gross income from rents, mortgage interest and property gains (95% including dividends and interest); have at least 100 shareholders and not be closely held; and keep no more than 25% of assets in taxable REIT subsidiaries, the corporate units that run non-qualifying services (raised from 20% for tax years beginning after 2025). The 90% test applies to taxable income, not cash; because depreciation lowers taxable income without using cash, payouts can exceed taxable income, the excess being a return of capital.
Nareit defines funds from operations (FFO) as GAAP net income excluding real estate depreciation, gains and losses on property sales, and related impairments. For a REIT with 100M shares: FFO = net income $120M + depreciation $180M − gain on sale $30M = $270M ($2.70 a share). Adjusted funds from operations (AFFO), which has no standard definition, also subtracts recurring capital spending ($50M) and non-cash straight-line rent ($10M): $210M ($2.10). A $1.80 dividend is 86% of AFFO; at $40 a share the REIT trades at 14.8× FFO and 19.0× AFFO, yielding 4.5%.
Ordinary REIT dividends are taxed as ordinary income, but the 20% §199A deduction, made permanent in July 2025, cuts the top federal rate on them from 37% to 37% × 0.80 = 29.6%.
Equity REITs, mortgage REITs and NAV. An equity REIT owns buildings and earns rent; a mortgage REIT owns loans or mortgage securities and earns the spread between their yield and its funding cost, so it behaves more like a leveraged bond fund than a landlord. For an equity REIT, analysts estimate net asset value (NAV): property NOI capitalized at current private-market cap rates, minus debt. Illustrative, for the REIT above: NOI $400M ÷ 6.0% = $6,667M of property, less $2,000M of debt = NAV $4,667M, or $46.67 a share on 100M shares. At $40 a share the REIT trades at a 14.3% discount to NAV, which means the stock market values its buildings at an implied cap rate of $400M ÷ ($4,000M + $2,000M) = 6.67%. The discount has consequences: a REIT that sells new shares below NAV dilutes its existing holders, so it stops buying; one trading at a premium can issue shares and buy buildings accretively. Listed prices reprice within days while appraisals take quarters, so a discount is often the market moving first.
Value an equity REIT on price ÷ AFFO and on price versus the net asset value (NAV) of its properties at current cap rates, not on dividend yield. If the dividend exceeds AFFO for more than a year, it is funded by borrowing or asset sales; treat it as at risk. This is a heuristic. For mortgage REITs, which hold loans, ignore FFO and use book value and net interest income.
Valuing a REIT on price ÷ earnings. In the example, earnings are $1.20 a share, so the REIT looks expensive at 33.3× while it trades at 14.8× FFO, because $1.80 a share of depreciation is a non-cash charge on buildings that often hold their value. The reverse error, treating FFO as free cash, ignores $0.50 a share of recurring capital spending. Use AFFO for cash and FFO for comparisons.
How are REIT dividends taxed in the US?
Most REIT dividends are ordinary income, not qualified dividends, because the REIT paid no corporate tax on them. Individuals may deduct 20% of ordinary REIT dividends under §199A, now permanent, so the top federal rate is 29.6% instead of 37%. Some of a dividend may be capital gain or return of capital.
Why do REIT prices fall when interest rates rise?
Higher rates raise the cap rates investors demand, lowering the value of a REIT’s buildings, and raise its borrowing costs as debt is refinanced. Listed REITs reprice daily while private appraisals adjust slowly, so the fall shows up in REIT prices first. REITs with inflation-linked rents are hurt less.
What is the difference between FFO and AFFO?
FFO adds real estate depreciation back to net income and removes property-sale gains, under Nareit’s standard definition. AFFO also subtracts recurring capital spending and non-cash rent, with no standard definition. Use FFO to compare REITs and AFFO to judge the cash available for dividends.
A US REIT escapes corporate tax by distributing at least 90% of its taxable income and meeting asset, income and ownership tests, so most of its dividends are taxed as ordinary income, softened by the permanent §199A deduction. Value equity REITs on FFO, AFFO and net asset value rather than earnings, and treat a dividend above AFFO as at risk.
Four questions on this chapter. Decide on your answer first, then click “Reveal Answer.”
1. A REIT with 50M shares reports net income of $80M, real estate depreciation of $110M and a $15M gain on a property sale. What is its FFO per share?
- $1.60
- $4.10
- $3.50
- $3.80
Reveal Answer
Answer: C. FFO = $80M + $110M − $15M = $175M; ÷ 50M shares = $3.50.
2. To keep its tax status, a US REIT must distribute at least 90% of what each year?
- Its cash flow from operations
- Its REIT taxable income
- Its GAAP net income
- Its funds from operations
Reveal Answer
Answer: B. Section 857 sets the 90% test on REIT taxable income, so depreciation lets payouts exceed it, the excess being a return of capital.
3. An equity REIT’s properties carry $60M of NOI, valued at a 6.0% cap rate, and it owes $400M of debt across 20M shares. Its shares trade at $24. What is the discount to NAV?
- 10%
- 25%
- 40%
- 20%
Reveal Answer
Answer: D. NAV = $60M ÷ 0.06 − $400M = $600M, or $30 a share; $24 ÷ $30 − 1 = −20%.
4. With the 20% §199A deduction, what is the top federal income tax rate on ordinary REIT dividends?
- 29.6%
- 37.0%
- 23.8%
- 20.0%
Reveal Answer
Answer: A. 37% × (1 − 0.20) = 29.6%; ordinary REIT dividends are not qualified dividends, so the 20% capital gains rate does not apply.
- FRED, 10-Year Treasury Constant Maturity (DGS10) — 1.52% (Dec 31, 2021), 4.98% (Oct 19, 2023), 5.24% (Oct 1, 2026)
- Federal Reserve, Financial Stability Report, May 2026: asset valuations — CRE price declines mid-2022 to early 2024, cap rates near historical average, maturing CRE debt
- 26 U.S.C. §856, definition of real estate investment trust — Asset, income, 100-shareholder and 25% TRS tests
- 26 U.S.C. §857, taxation of REITs — 90% distribution requirement on REIT taxable income