The cap rate, or capitalization rate, in real estate is a metric used to estimate the rate of return on an income-producing property based on its net operating income (NOI) and current market value. It is calculated by dividing the property's NOI by its market value and expressing the result as a percentage:
Cap Rate=Net Operating Income (NOI)Property Value×100%\text{Cap Rate}=\frac{\text{Net Operating Income (NOI)}}{\text{Property Value}}\times 100%Cap Rate=Property ValueNet Operating Income (NOI)×100%
- Net Operating Income (NOI) is the annual income generated by the property (rents plus any ancillary income) minus operating expenses (such as property taxes, insurance, maintenance), excluding mortgage payments or financing costs.
- Property Value is the current market value or purchase price of the property.
The cap rate serves as a shorthand for the expected annual return on the investment, reflecting both the income potential and the implied risk of the property. A higher cap rate generally indicates higher potential returns but also higher risk, while a lower cap rate suggests lower returns and lower risk. It is widely used by investors to compare the relative attractiveness of different real estate investments and to estimate property values based on expected income
. In summary, the cap rate answers the question: For each dollar spent to acquire the property, what is the expected annual net operating income generated? It is a key tool in commercial real estate investment analysis but should be used alongside other metrics since it does not account for financing, future cash flows, or property improvements
