Cap Rate (Capitalization Rate)
A property's annual operating income as a percentage of its value.
Quick Answer
A capitalization rate, or cap rate, is a property's annual net operating income divided by its market value or purchase price, expressed as a percentage. It gives a quick, unlevered measure of income yield, letting investors compare properties and estimate value by dividing income by a market cap rate.
The Full Picture
The cap rate formula is simple: net operating income (NOI) divided by property value. If a building produces 1,000,000 dollars of NOI and sells for 15,000,000 dollars, the cap rate is about 6.7 percent. NOI is rental income and other revenue less operating expenses such as taxes, insurance, maintenance, and management, and it excludes debt service and usually capital expenditures.
Cap rates work in two directions. Investors divide NOI by price to see the yield they would get, and appraisers and brokers divide NOI by a market cap rate to estimate value. Lower cap rates generally reflect higher prices relative to income, which usually signals lower perceived risk or stronger growth expectations, while higher cap rates tend to indicate higher perceived risk or lower growth.
Cap rate is a snapshot, not a full return measure. It ignores financing, the time value of money, future income growth, and the capital needed to improve the property. Metrics such as internal rate of return and equity multiple capture those effects. Cap rates also vary by property type, market, and asset quality, so comparisons are only meaningful among similar properties.
In development, a related measure called yield on cost divides projected stabilized NOI by total development cost. Developers compare that yield to the market cap rate to see whether building creates value, since a spread between the two is the incentive to take on development risk. Construction cost estimates therefore feed directly into this analysis.
Real Examples
Common Misconceptions
People assume: A higher cap rate always means a better investment.
Actually: A higher cap rate often reflects higher risk, weaker location, or lower growth. It has to be judged against property quality, market, and risk.
People assume: Cap rate measures total investment return.
Actually: It reflects only a single year's unlevered income yield. It ignores financing, income growth, capital needs, and the eventual sale.
Frequently Asked Questions
How do you calculate cap rate?
Divide net operating income by the property's value or purchase price and express the result as a percentage. NOI excludes debt payments and typically income taxes and capital expenditures.
What is a good cap rate?
There is no universal answer. It depends on property type, market, asset quality, interest rates, and the investor's risk tolerance. Compare against similar properties in the same market.
What is the difference between cap rate and yield on cost?
Cap rate compares NOI to a property's market value or price. Yield on cost compares projected NOI to the total cost to develop the property.
Does cap rate include financing?
No. Cap rate is an unlevered measure, so it ignores mortgage payments and the effect of leverage on investor returns.
How do cap rates relate to property value?
Value equals NOI divided by the cap rate. If market cap rates rise while NOI stays constant, value falls, and if they fall, value rises.