Cap Rate (Capitalization Rate)
Cap rate is a real estate investment metric calculated by dividing a property's Net Operating Income (NOI) by its current market value or purchase price, expressed as a percentage to evaluate potential return.
Exam Tip
Cap Rate = NOI / Value. Higher cap rate = higher risk/return. NOI excludes mortgage payments. Know how to calculate value from cap rate!
What is Cap Rate?
Cap rate (capitalization rate) is the most widely used metric for evaluating the potential return of an income-producing property. It helps investors compare properties and assess risk levels.
The Cap Rate Formula
Cap Rate = Net Operating Income (NOI) / Property Value (or Purchase Price)
Example:
- Property Value: $1,000,000
- Annual NOI: $80,000
- Cap Rate = $80,000 / $1,000,000 = 8%
Understanding Net Operating Income (NOI)
| Component | Description |
|---|---|
| Gross Rental Income | Total potential rent |
| - Vacancy Allowance | Expected vacancy losses |
| - Operating Expenses | Property taxes, insurance, maintenance, management |
| = Net Operating Income | Income before debt service |
Important: NOI does NOT include mortgage payments, depreciation, or capital expenditures.
Using Cap Rate to Calculate Value
You can also use cap rate to estimate property value:
Property Value = NOI / Cap Rate
Example:
- NOI: $50,000
- Market Cap Rate: 6%
- Property Value = $50,000 / 0.06 = $833,333
What Cap Rates Mean
| Cap Rate | Risk/Return | Typical Property Type |
|---|---|---|
| 3-5% | Lower risk, lower return | Prime locations, Class A properties |
| 5-7% | Moderate risk/return | Suburban, stable markets |
| 7-10% | Higher risk, higher return | Secondary markets, older properties |
| 10%+ | Highest risk | Distressed, value-add opportunities |
Factors That Affect Cap Rates
| Factor | Effect on Cap Rate |
|---|---|
| Location | Better location = lower cap rate |
| Property Condition | Better condition = lower cap rate |
| Interest Rates | Higher rates = higher cap rates |
| Market Demand | More demand = lower cap rates |
| Tenant Quality | Better tenants = lower cap rate |
| Lease Terms | Longer leases = lower cap rate |
Cap Rate Limitations
| Limitation | Description |
|---|---|
| Ignores Financing | Doesn't account for leverage |
| Snapshot in Time | Based on current NOI only |
| Varies by Market | Can't compare across markets |
| Ignores Appreciation | Only measures income return |
Cap Rate vs. Cash-on-Cash Return
| Metric | Formula | Considers Financing? |
|---|---|---|
| Cap Rate | NOI / Purchase Price | No |
| Cash-on-Cash | Cash Flow / Cash Invested | Yes |
Exam Alert
- Cap Rate = NOI / Property Value (memorize this formula!)
- NOI does NOT include mortgage payments
- Higher cap rate = higher risk and return
- Lower cap rate = lower risk, typically better location
- Can use cap rate to calculate property value: Value = NOI / Cap Rate