Cap-rate decomposition

A capitalization rate is the first-year unlevered yield on a property: cap rate = NOI ÷ value (or price). Everything below hangs off that identity — but a usable analysis does three things the raw formula does not: it separates the entry yield from the exit yield, it explains why a given cap rate is what it is, and it puts comps on a common footing before treating them as evidence of a market rate.

Use net operating income that is truly net: after a capital-reserve deduction and stripped of one-time items. A cap rate computed on an NOI that still carries a non-recurring insurance recovery or omits a replacement reserve is not comparable to one that is clean.

1. Going-in vs. terminal cap

• Going-in (entry) cap = Year-1 forward NOI ÷ purchase price. It is the yield the

buyer locks in at acquisition.

• Terminal (exit / reversion) cap = the NOI of the year after sale

(Year N+1, the first year of the next owner's hold) ÷ projected sale price. You apply it to forward NOI, not the year you sell in.

Set the terminal cap at or above the going-in cap. The asset is older and further from its warranty/capex cycle at exit, and the future is less certain, so a spread is added — typically +25 to +75 bps over the going-in cap for a stabilized hold, wider for shorter-lived or more cyclical assets. Holding the terminal equal to going-in (or below it) assumes the asset gets better with age and should be flagged as aggressive.

2. Build up the cap rate from its parts

A cap rate is not an opaque market number — it is a required return net of growth. Decompose it so you can judge whether the quoted rate compensates for the actual risk:

required return (discount rate) = risk-free rate
                                + general real-estate risk premium
                                + property-specific risk premium
cap rate ≈ required return − expected long-run NOI growth (g)

Typical / illustrative bands — calibrate to the current market, do not treat as fixed:

| Component | What it pays for | Typical band | |-----------|------------------|--------------| | Risk-free rate | Time value; use the current 10-yr Treasury | the live 10-yr yield | | General RE risk premium | Illiquidity + real-asset / sector risk over bonds | ~150–300 bps | | Property-specific premium | The add-ons below, summed | ~0–400 bps | | less: expected NOI growth (g) | Rent-growth outlook over the hold | ~100–300 bps |

The property-specific premium is itself a sum of add-ons. Each of these widens the cap (raises required yield):

• Asset class — Class A ≈ +0; Class B ≈ +25–75 bps; Class C ≈ +75–150 bps.
• Market tier — gateway ≈ +0; secondary ≈ +25–75 bps; tertiary ≈ +75–150 bps.
• Tenant credit & rollover — weak credit, short WALT (weighted-average lease term),

or heavy near-term rollover ≈ +0–150 bps.

• Physical / deferred capex — meaningful deferred maintenance ≈ +0–100 bps.

So two assets can share a headline cap rate for very different reasons: a Class C tertiary-market building at 8% is priced for its risk stack, while a Class A gateway asset at 8% would signal distress or expected NOI decline. Reconcile the quoted cap against this build-up; a large gap is the thing to explain.

3. Normalize comps before you compare

Observed sale cap rates are only evidence of a market rate if the NOIs behind them are defined the same way as the subject's. Before averaging comps or reading a market cap, put every comp on the subject's basis:

Occupancy. A cap rate computed on in-place NOI at 78% occupancy is not comparable to one at stabilized 94%. Restate each comp's NOI to a stabilized economic occupancy — mark the vacant space to market rent, then subtract a stabilized vacancy and credit-loss factor — and compare on that basis. Comparing an in-place-occupancy cap to a stabilized cap silently mixes a lease-up discount into the "market rate."

Lease structure (NNN vs. gross). NOI is defined differently under different leases, so their cap rates are not directly comparable:

• Under a triple-net (NNN) lease the tenant pays taxes, insurance, and CAM, so the

landlord's NOI ≈ base rent (few landlord-borne operating expenses).

• Under a gross / full-service lease the landlord pays operating expenses, so

NOI = gross rent − landlord operating expenses, a margin often 25–40% below the gross rent.

Never compare an NNN cap rate to a gross cap rate as-is. Restate all comps to the same expense-responsibility basis as the subject — e.g., gross up the NNN comp to a full- service equivalent (add the reimbursed expenses to both rent and opex) or net the gross comp down — so the NOIs are on one footing before you draw a market cap.

Also normalize for below/above-market in-place rents (mark toward market so the cap reflects economic, not contractual, income) and strip one-time items from every comp's NOI. Only after occupancy, lease structure, mark-to-market, reserves, and non-recurring items are aligned is the spread of comp cap rates meaningful.