Cap rate is the most quoted number in commercial real estate and one of the most misunderstood. It is a useful shorthand for yield, but it is only as honest as the income figure behind it. In a market like Los Angeles, where cap rates run lower than much of the country, that confusion costs buyers real money. Here is what the number actually means, where it misleads people, and how to use it without getting burned.
The Formula
Cap rate is net operating income divided by price. NOI is the building’s annual income after operating expenses but before any mortgage payment. Divide it by the purchase price and you get a percentage that describes the unleveraged yield: what the building returns if you paid all cash.
Say a building produces $80,000 of NOI and sells for $1.6 million. That is a 5 percent cap rate. Flip the formula and cap rate also sets price. If you know a submarket trades at a 5 percent cap and you find a building with $100,000 of NOI, the implied value is $2 million. This is why operators care so much about NOI: in a stabilized building, every dollar of added income is worth twenty dollars of value at a 5 percent cap.
Actuals vs. Pro Forma: Where Buyers Get Burned
The formula is simple. The trap is the income number you feed it. Sellers advertise cap rates built on pro forma NOI, which is the income the building could produce after rent increases, renovations, or turnover that has not happened yet. A building marketed at a 5.5 percent cap on pro forma might be a 4 percent cap on the rents tenants actually pay today.
Always recalculate the cap rate on actual, in-place income before you judge a price. Pull the real rent roll and the real expenses. The pro forma cap rate tells you what the seller hopes you will believe. The actual cap rate tells you what you are buying. Treat the gap between them as work you have to do, not value you already own.
Why Low LA Cap Rates Can Still Make Sense
Investors from other markets see Los Angeles cap rates and assume the deals are overpriced. Sometimes they are. But a low cap rate is not automatically a bad buy, and here is why.
Cap rate is an inverse of price. A low cap rate means a high price relative to current income, which the market assigns to buildings where the income is expected to grow or the risk of losing it is low. In a supply-constrained market with strong long-term demand, buyers accept a lower current yield in exchange for expected rent growth and appreciation. They are paying for the future, not just the present.
A 4 percent cap in a desirable LA submarket with rising rents can outperform a 7 percent cap in a market with flat demand and high vacancy risk, once you account for growth and the durability of the income. The cap rate is a snapshot. The investment is a movie. Just be honest that a low cap rate means you are betting on growth, and make sure that bet is grounded in the submarket, not in hope.
Cap Rate vs. Cash Flow
Here is a distinction that trips up new buyers: cap rate ignores your financing entirely. It describes the building’s yield as if you paid all cash. Cash flow is what lands in your pocket after the mortgage. Two buildings can share the same cap rate and produce wildly different cash flow depending on how each is financed.
A building at a 5 percent cap rate with a loan that costs 6 percent will have negative leverage: the debt eats into your return, and cash flow can be thin or negative even though the cap rate looks fine. Cap rate helps you compare buildings against each other. Cash flow tells you whether you can actually hold the property. You need both. For the cash-flow side of the analysis, our companion guide on analyzing rental property cash flow walks through how financing turns a cap rate into the money you keep.
Compare Within the Submarket, Not Across the Map
A cap rate only means something next to the cap rates of comparable buildings in the same area. A 5 percent cap in one LA neighborhood may be a screaming deal; the same 5 percent two miles away may be rich. National averages are useless here. Demand, rent-control exposure, tenant quality, and building age all shift what a fair cap rate is block by block.
So gather the recent sales of similar buildings in the same submarket and see where they traded. That local range is your benchmark. A building priced at a cap rate well above the local norm is either a bargain or a warning, and diligence tells you which. One priced well below the norm had better come with growth or quality that justifies it. To pressure-test those local comps and the income behind them, our checklist on real estate due diligence in Los Angeles covers what to verify.
Operator’s Note
When someone leads with a cap rate, our first question is always the same: actual or pro forma? Half the time the answer reveals the whole deal. A confident seller quoting a strong cap rate on projected rents is showing you the destination and charging you for the trip. The number that should drive your offer is the actual cap rate on today’s income, in this submarket, against today’s financing. Everything past that is the upside you have to earn, and you should price it as a possibility, not a fact.
Bottom Line
Cap rate is NOI divided by price, a quick read on unleveraged yield and a lever that sets value in income-driven deals. Use it on actual income, not pro forma. Understand that low LA cap rates often reflect expected growth rather than overpricing. Pair it with cash flow, because financing decides whether you can hold what you buy. And only compare it within the same submarket. Used that way, the cap rate is one of the sharpest tools you have. Used carelessly, it is the fastest way to overpay.
If you want help reading the cap rates on a building you are weighing, or sorting actual from pro forma on a deal in front of you, reach out to our team.