What Is a Cap Rate?

A cap rate, or capitalization rate, is a measure in commercial real estate that represents the return on an investment over a specified time period — usually one year — that is expected from an income-generating investment property. Cap rates can be easily calculated by dividing the property’s net operating income by its market value. Once calculated, the cap rate is expressed as a percentage.

Appraisers often scrutinize property cap rates to determine commercial property values, and it is the key metric behind the income capitalization approach to property valuation. 

Cap Rate Calculator

Use the calculator below to figure out the cap rate for any property. Need a clearer picture on how the calculation works? Read on below.

Calculating Your Cap Rate

In order to get a clearer picture on how to calculate a cap rate, imagine a property with a NOI of $500,000 and a market value of $10 million. This property would have a capitalization rate of 5.0%, calculated below.

Cap Rate Formula

Cap Rate = Net Operating Income ÷ Current Market Value

 In our example, the NOI of $500,000, divided by the market value of $10 million, results in a cap rate of 5.0%. 

Understanding and Utilizing Cap Rates

Cap rates serve as a way to identify the length of time it will take an investor to recover its investment in an asset. For example, a property that has a cap rate of 10% could reasonably be expected to generate enough income to recoup the investor’s stake in the property in 10 years. Additionally, the relationship between a property’s NOI and cap rate can be used to determine the property value when taken in comparison with the cap rates of similar properties — that is, commercial properties of similar age and asset class — in a given market.

A property’s capitalization rate can be useful in making rough comparisons to the relative value of similar properties on the market. However, it should not be taken as the sole indicator of an investment property’s profitability. This is because the calculation disregards certain key factors such as leverage.

What Is a Good Cap Rate?

Capitalization rates are based on projected estimates of future income. Therefore, it should be easy to understand that capitalization rates are subject to variation. It is completely up to the investor to understand what constitutes a good cap rate for each individual investment opportunity. In regards to commercial real estate loan programs, there are no industry-defined ranges for a good or bad cap rate, and the ranges that present themselves to investors are typically wholly dependent on the health and performance of the property and its market.

The variances that can be found in cap rates are all about investment risk. There are a variety of different cap rates among different properties, and even different cap rates that account for different time horizons for the same investment property.

Each cap rate measurement represents a different level of risk. A higher cap rate value typically translates to a higher net operating income and a lower valuation, and vice versa. Even so, what constitutes an acceptable level of risk is something that each investor must decide for themselves.