Capitalization Rate
IntermediateThe capitalization rate, or cap rate, is a measure of a property’s return, calculated by dividing its annual net operating income by its value or purchase price.
The cap rate shows the income return a property produces relative to its price, before financing costs. It is widely used to compare commercial properties and estimate their value.
For example, a property producing net operating income of 60,000 a year and priced at 1,000,000 has a cap rate of 6%.
The formula can also be used in reverse to value a property. If similar properties sell at a cap rate of 6%, a property producing 60,000 of net operating income might be valued at about 1,000,000.
Cap rates reflect risk and market conditions. Lower cap rates mean higher prices relative to income, typical of prime properties in strong locations with secure tenants. Higher cap rates indicate higher risk or weaker demand. Cap rates tend to rise when interest rates rise, pushing property values down. The cap rate is a snapshot that ignores future rent growth, financing and capital spending, so investors use it alongside other measures, such as cash flow forecasts and internal rate of return.
For worked examples and full lessons, visit notesbysara.org.