Definition
The Capitalization Rate (Cap Rate) is a real estate investment metric that measures the potential return on an income-producing property. It is calculated by dividing the property’s Net Operating Income (NOI) by its purchase price (or current market value). The cap rate helps investors evaluate the profitability and risk of different properties.
Explanation
Cap rate is used to compare investment properties, especially in commercial real estate. A higher cap rate typically indicates a higher return but greater risk, while a lower cap rate suggests a safer but less lucrative investment.
Formula for Cap Rate:
Cap Rate = (Net Operating Income (NOI) / Property Value) × 100
Where:
- Net Operating Income (NOI) = Total Rental Income – Operating Expenses (excluding mortgage payments).
- Property Value = The current market value or purchase price of the property.
Cap Rate Benchmarks:
| Cap Rate Range | Market Type | Risk Level |
|---|---|---|
| 2% – 5% | Prime urban areas (NYC, LA) | Low risk, stable income |
| 5% – 8% | Strong rental markets | Moderate risk, good balance |
| 8% – 12%+ | Emerging or distressed areas | High risk, high potential returns |
Example Calculation
An investor buys a rental property for $500,000 with the following income and expenses:
- Annual Rental Income: $50,000
- Operating Expenses (taxes, maintenance, insurance): $10,000
- Net Operating Income (NOI): $40,000
Cap Rate=(40,000/500,000)×100=8%
n 8% cap rate suggests a moderate-risk, good return investment.
How Cap Rate Helps Investors:
✅ Compares properties in different markets.
✅ Assesses investment risk before purchasing.
✅ Helps determine if a property is overpriced or undervalued.