Capitalization Rate
What Is Capitalization Rate?
Capitalization rate, or cap rate, is a metric used to evaluate the expected return on an income-producing property.
It is calculated by dividing net operating income by the property’s current market value.
Formula:
Capitalization Rate = Net Operating Income ÷ Market Value
Cap rate is commonly used in commercial real estate analysis.
Why It Matters
Capitalization rate:
- Estimates potential investment return
- Helps compare properties
- Reflects market risk
Higher cap rates often indicate higher risk or weaker demand. Lower cap rates may signal stable or high-demand markets.
Cap rate does not account for financing costs.
How Capitalization Rate Works
Capitalization rate measures the annual income a property generates relative to its market value.
Investors calculate net operating income by subtracting operating expenses from rental income.
The result is divided by the property value to determine the percentage return.
Cap rate serves as a valuation benchmark, not a guaranteed yield.
Capitalization Rate vs. Cash-on-Cash Return
Capitalization Rate → Based on total property value
Cash-on-Cash Return → Based on investor’s actual cash invested
Financing impacts cash-on-cash return.
FAQs About Capitalization Rates
Does cap rate include mortgage payments?
No, it excludes financing costs.
Is a higher cap rate better?
Higher cap rates may indicate higher risk.
Can cap rates change over time?
Yes, market conditions influence cap rates.
Related Terms
