A capitalization rate, or cap rate, is a key real estate metric used to estimate the rate of return on an investment property based on the income it generates. It is calculated by dividing the property's net operating income (NOI) by its current market value or purchase price, and is expressed as a percentage:
Cap Rate=Net Operating Income (NOI)Current Market Value or Purchase Price\text{Cap Rate}=\frac{\text{Net Operating Income (NOI)}}{\text{Current Market Value or Purchase Price}}Cap Rate=Current Market Value or Purchase PriceNet Operating Income (NOI)
For example, if a property generates $80,000 in NOI annually and is valued at $1 million, the cap rate is 8% ($80,000 ÷ $1,000,000)
. The cap rate reflects the yield an investor can expect from the property over a one-year period, assuming the property is bought with cash (no financing). It serves as a quick way to compare the relative value and risk of similar real estate investments. Generally, a higher cap rate indicates higher risk and potentially higher returns, while a lower cap rate suggests lower risk and lower returns
. Cap rates are derived from the concept of valuing a perpetuity-an income stream expected to continue indefinitely-where the property value equals the annual income divided by the expected rate of return
. While useful, cap rates should not be the sole factor in investment decisions since they do not account for leverage, future cash flow changes, or the time value of money
. In summary, the cap rate is a fundamental measure in commercial real estate that helps investors estimate the expected annual return on a property relative to its price, aiding in valuation and comparison of investment opportunities.
