Defining Capitalization (Cap) Rate
The capitalization, or cap, rate is a valuation method most commonly used in real estate investing and is based on a property’s unlevered yield (rate of return). In other words, a cap rate measures a property’s natural rate of return for a single year without taking into account any debt on the asset, making it easy to compare the relative value of one property to another. A cap rate is usually expressed as a percentage value.
While the cap rate can be useful for quickly comparing the relative value of similar real estate investments in the market, it should not be used as the sole indicator of an investment’s strength because it does not take into account leverage, the time value of money, and future cash flows from property improvements, among other factors.
A property’s cap rate is calculated by dividing annual net operating income (NOI), or the cash flow after property expenses, by the sales price or value of the property:
How to Calculate Cap Rate
For example, a property that costs $10 million to purchase and has an annual net operating income of $700,000 would have a cap rate of 0.07 or 7%.
The cap rate of a property can fluctuate if either NOI or value changes. Because value can be impacted by many outside forces such as market demand or interest rates, often the cap rate for a single property may go up or down even if there was no physical change to the property or the amount of income it produced.
For example, in today’s low-interest rate environment, cap rates for commercial real estate properties are at an all-time low for almost every asset class.
Learn More about Cap Rate
To learn more about the capitalization (cap) rate and how it can be used to evaluate real estate, check out this video from Wharton Real Estate Professor Peter Linneman.