Commercial valuation math
Cap rate connects property income to value—not to the mortgage rate
Capitalization rate connects a property's normalized NOI with its value. Small changes in the cap rate assumption can produce large value changes, which can then change LTV and the amount a lender is prepared to advance.
Cap rate is NOI divided by property value
Capitalization rate = normalized annual NOI ÷ property value × 100. If a property produces $250,000 of normalized NOI and is valued at $5,000,000, its implied cap rate is 5.00%.
The same relationship can be rearranged to estimate value: property value = normalized NOI ÷ cap rate. That makes cap-rate assumptions extremely important in income-property valuation.
If the formulas are not the point of your visit, use the Cap Rate Calculator here. If NOI itself is uncertain, establish it first with the NOI Calculator; otherwise a precise cap-rate calculation can still be built on the wrong numerator.
The NOI has to be normalized before the cap-rate math means anything
An appraiser or lender may not accept the owner's reported cash flow exactly as presented. Rent, vacancy, management, repairs, taxes, insurance and other operating expenses may be normalized to produce a sustainable NOI.
Because cap rate is a division problem, an overstated NOI directly overstates implied value. Use NOI Calculator as the first step when the numerator is not already established.
Use cap-rate math in both directions: test the implied cap rate and the implied value
When price and NOI are known, calculate the implied cap rate and ask whether it is credible for that property and market. When NOI and a market-supported cap rate are known, calculate the implied value and compare it with the purchase price or appraisal expectation.
Running the relationship both ways is a useful error check. If the purchase price requires an unusually aggressive cap rate to work, the financing plan may be depending on a valuation assumption rather than on the property's actual income.
Use the Cap Rate Calculator to switch between these views, then test the lender consequence through Commercial LTV.
Worked example: the same $250,000 NOI can imply very different values
At a 5.00% cap rate, $250,000 of NOI implies $5.00 million of value. At 6.00%, the same NOI implies about $4.17 million. At 4.50%, it implies about $5.56 million.
Nothing about the building's NOI changed in that illustration. The value moved because the capitalization-rate assumption changed.
| Cap-rate assumption | Normalized NOI | Implied value |
|---|---|---|
| 4.50% | $250,000 | $5.56M |
| 5.00% | $250,000 | $5.00M |
| 5.50% | $250,000 | $4.55M |
| 6.00% | $250,000 | $4.17M |
Stress NOI and cap rate together because valuation risk can come from either side of the equation
The most dangerous valuation scenario is not always a cap-rate move by itself. If normalized NOI falls while the market-supported cap rate rises, both parts of value = NOI ÷ cap rate move against the borrower at the same time.
For example, $250,000 NOI at 5.00% implies $5.00 million. If NOI falls 10% to $225,000 and the cap rate rises to 6.00%, implied value falls to $3.75 million. A financing plan built around the original $5 million value would now have a very different LTV and equity requirement.
Use the NOI Calculator to build a conservative numerator and the Cap Rate Calculator to test several cap rates before relying on one appraisal expectation.
| Scenario | NOI | Cap rate | Implied value |
|---|---|---|---|
| Base | $250,000 | 5.00% | $5.00M |
| NOI -10% | $225,000 | 5.00% | $4.50M |
| Cap rate +1% | $250,000 | 6.00% | $4.17M |
| Both move | $225,000 | 6.00% | $3.75M |
A cap-rate change can become a mortgage problem through the lender's accepted value
Suppose the borrower expects a $5 million value and requests a $3.75 million mortgage: that is 75% LTV. If the lender's appraisal supports only about $4.17 million, the same loan would be roughly 90% LTV—far beyond what many commercial structures would support.
The borrower may therefore face a lower loan amount or a larger equity requirement even though the requested debt and property cash flow have not changed. See Commercial LTV and Commercial Appraisals.
Cap rate is a market input, not a number the borrower chooses
The appropriate capitalization rate can depend on location, property type, lease terms, tenant quality, remaining lease duration, building condition, market liquidity and comparable transactions. The lender may rely on an appraisal or other valuation evidence rather than the borrower's preferred cap rate.
That is why a mortgage analysis should test a range rather than reverse-engineering the one cap rate needed to justify the requested loan.
Cap rate, debt yield and mortgage rate are three different percentages
Cap rate uses NOI ÷ property value. Debt yield uses NOI ÷ loan amount. Mortgage interest rate is the price charged on the debt. A property can have a 5% cap rate, a 6.25% debt yield and a completely different mortgage interest rate at the same time.
DSCR is different again because it compares NOI with annual principal-and-interest debt service.
| Measure | Denominator | What it tells you |
|---|---|---|
| Cap rate | Property value | Income/value relationship |
| Debt yield | Loan amount | Income/debt relationship |
| DSCR | Annual debt service | Payment coverage |
| Mortgage rate | Loan pricing basis | Price of borrowing |
Cap-rate sensitivity should be part of the financing plan before the appraisal arrives
A 100-basis-point shift from 5% to 6% reduced the illustrative value from $5.00 million to about $4.17 million—roughly a 16.7% decline in value with NOI held constant. That is why cap-rate risk can create a material financing shortfall.
Before waiving conditions or committing equity, model a range of NOI and cap-rate combinations using the Cap Rate Calculator.
Cap rate is a valuation lens, not a complete commercial mortgage decision
A plausible cap rate does not establish that the tenant income is durable, the borrower has enough liquidity, environmental diligence is clean, the property is marketable or the requested debt can be serviced.
Use cap rate beside DSCR, debt yield, LTV, lease review, appraisal evidence and borrower strength.
Sources and methodology
Sources and verification
Cap rates are market- and property-specific valuation inputs. This page explains the mathematical relationship without presenting a single cap rate as appropriate for every Ontario property.