What Is the Capitalization Rate (Cap Rate)

The Cap Rate (Capitalization Rate) is the ratio of the net operating income (NOI) a property generates to its asset value. It corresponds to the annual return if you bought the property with cash and no loan.

The formula is simple.

Cap Rate = Net Operating Income (NOI) / Asset Value

For example, if a building's first-year NOI is $80,000 and its price is $1 million, the cap rate is 8%.

Here, NOI is the annual rental income minus operating expenses such as property tax, insurance, management, and maintenance (loan interest is excluded).

The cap rate is also used in reverse. If you know the cap rate prevailing in the market, you can back out a property's value.

Value = Net Operating Income (NOI) / Market Cap Rate

For example, if NOI is $60,000 and the market cap rate is 6%, the property's estimated value is $1 million.

Generally, the higher the cap rate, the higher the potential return but also the higher the risk. Conversely, a low cap rate looks safe but comes with lower expected returns.

The cap rate is convenient, but you should know it leaves out important things.

1. It does not reflect leverage (loans). In practice, loan interest changes returns significantly. 2. It does not capture the future. The cap rate is only a snapshot of 'now' and does not reflect changes like rising vacancy, falling rents, or rising costs. 3. It can be distorted by how NOI is calculated. Understating operating expenses makes the cap rate look better.

Also, when market interest rates rise, cap rates tend to rise too, which can mean a decline in property value (the same NOI is worth less). The cap rate is only the starting point of a real estate investment; you cannot judge safety by it alone.