How to Calculate Commercial Real Estate Value (My Cap Rate Trick)

By Jeremy Cyrier, CCIM, CRE

Commercial real estate is a highly valuable asset, but understanding exactly what it’s worth can feel like a guessing game.

I get this question all the time: “What’s a good cap rate?”

It’s a complicated question. Most people want to know what a “good” cap rate is simply because they want to benchmark against what someone else paid. I don’t like using that approach at all. Comparable cap rates are certainly helpful, but I actually prefer to build my own cap rate from the ground up.

Today, I’m going to share a tool and a methodology we use at MANSARD to develop a valuation. It relies on a cap rate that is based on real-world assumptions—specifically, data from the debt market, your desired cash-on-cash return, and the property’s Net Operating Income (NOI).  

If you want to know how to calculate commercial real estate value accurately, here is the trick I use.

The Standard Way Investors Value Commercial Property

To start, you need to find the gross operating income for a property.

Let’s say your property generates $750,000 a year in revenue, and it costs you $200,000 a year to operate it. That gives you a Net Operating Income (NOI) of $550,000. It’s a pretty quick way to arrive at that baseline number.

Most of the time, investors will stop right here and just slap a market cap rate on it. They’ll ask around, find out that market cap rates are hovering around 7%, and divide that $550,000 by 7% to come up with a commercial real estate value.

Don’t stop here.

That’s exactly why we built a more precise tool. We want a higher degree of accuracy when determining what the cap rate should be for a specific deal. (A quick shout-out to Mike Lipsey for turning me onto the concept behind this tool, which I’ve since developed into my own version.)

How Interest Rates Affect Cap Rates

To build our own cap rate, we first have to look at the amortization period.

Typically, when you go to a commercial lender, you’re going to see amortization periods of 15, 20, 25, or maybe even 30 years. For this example, let’s assume a 25-year amortization period and an interest rate of 5.25%.

Interest rates naturally go up and down. You might see them at a low point of 3% or 3.5%, or they could climb to 6% or higher. For our math today, 5.25% is a solid baseline.

Next, we need to figure out our loan-to-value (LTV) ratio. These vary widely depending on the lender and the deal—you might see an LTV anywhere from 80% down to 30%. For this scenario, we’re going to use a standard 70% LTV.

Factoring in Cash-on-Cash Returns

Once we have our debt assumptions, we need to look at the equity side.

Because we have a 70% LTV, that means 30% of the purchase price is coming out of the investor’s pocket as equity. Naturally, that investor is going to want a specific cash-on-cash return on that money.

If we make an assumption about what that cash-on-cash return should be, we can generate a cap rate that actually supports it.

Let’s say the investor is looking for a 10% cash-on-cash return. Plugging that into our tool alongside the debt terms gives us an 8.03% cap rate. That cap rate is a blended rate made up of 70% debt and 30% equity. (This is how almost every piece of commercial real estate is bought, unless it’s an all-cash deal.)

What this calculation allows you to do is say: “Okay, at a valuation of $6.8 million and an 8.03% cap rate—assuming the NOI is $550,000—I can successfully achieve a 10% cash-on-cash return.”

How to Calculate Commercial Real Estate Value When the Market Shifts

What happens if the investor lowers their cash-on-cash return requirement?

Let’s say they are willing to accept an 8.25% return instead of 10%. Because we are adjusting the cost of equity over a fixed cost of debt (5.25%), our required cap rate drops to 7.51%. As that cap rate comes down, the valuation of the property goes up.

Now, let’s look at it from the debt side. Let’s say you call your bank to check prevailing rates, and they tell you they can finance the deal at 5.85%, but they are only comfortable with a 65% LTV.

If you still want an 8% cash-on-cash return under those new lending terms, the right cap rate for the property becomes 7.84%. Based on our $550,000 NOI, that gives the property an estimated value of roughly $7 million.

As you move these assumptions around—adjusting interest rates, LTV, and desired returns—the cap rate adjusts with them.

The Band of Investment Theory

This approach is known as the band of investment theory. It is an incredibly helpful way to build a cap rate because it factors in both the cost of financing and the cost of equity.

Instead of just guessing based on what other people are paying, this method tells you what can actually be financed in the market and what will be attractive to investors. I built this tool myself in Excel. It’s quick, it’s easy, and it gives you a smooth, clean way to arrive at a commercial real estate value that is perfectly tailored to what you are trying to accomplish.