Capitalization Rate

What is it?

The capitalization rate, also known as cap rate, is one of the most widely touted metrics in real estate investing. It is essentially the net operating income of an investment property divided by the asset's value. It was adopted as a way to compare investment opportunities without consideration for how they are financed. Cap rate represents the un-leveraged rate of return of an asset over one year.

Why is it important?

Capitalization rate by itself should not be used as a sole measure of investment worthiness. A more holistic view of the investment property is required to determine if it is suitable for an individual's investment objectives. However, all else being equal in two different assets, the cap rate is a good metric to differentiate between the two and select one to invest in.

How it is calculated?

Simply put, the capitalization rate is determined by calculating the net operating income of an asset (NOI), revenue less operating expenses, and dividing it by the market value of the asset (many times the purchase price in real estate). The mathematical expression is as follows.

Rental Property Example

First, we need to calculate the net operating income of the property which equates to rental revenue less all operating expenses.

Next, we take the net operating income calculated in step one and divide it by the purchase price (or current market value) to get the cap rate of the property.

This exercise can be replicated across many properties and used to compare expected returns. The higher the capitalization rate, the higher the expected return of the property.

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