# Capitalization Rate

« Back to Glossary Index

## What Is Capitalization Rate?

The capitalization rate (also known as cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. This measure is computed based on the net income which the property is expected to generate and is calculated by dividing net operating income by property asset value and is expressed as a percentage. It is used to estimate the investor’s potential return on their investment in the real estate market.

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. There are no clear ranges for a good or bad cap rate, and they largely depend on the context of the property and the market.

### Key Takeaways

• Capitalization rate is calculated by dividing a property’s net operating income by the current market value.
• This ratio, expressed as a percentage, is an estimation for an investor’s potential return on a real estate investment.
• Cap rate is most useful as a comparison of relative value of similar real estate investments.

## Understanding Capitalization Rate

Cap rate is the most popular measure through which real estate investments are assessed for their profitability and return potential. The cap rate simply represents the yield of a property over a one year time horizon assuming the property is purchased on cash and not on loan. The capitalization rate indicates the property’s intrinsic, natural, and un-leveraged rate of return.

## Capitalization Rate Formula

Several versions exist for the computation of the capitalization rate. In the most popular formula, the capitalization rate of a real estate investment is calculated by dividing the property’s net operating income (NOI) by the current market value. Mathematically,

Capitalization Rate = Net Operating Income / Current Market Value

where,

The net operating income is the (expected) annual income generated by the property (like rentals) and is arrived at by deducting all the expenses incurred for managing the property. These expenses include the cost paid towards the regular upkeep of the facility as well as the property taxes.

The current market value of the asset is the present-day value of the property as per the prevailing market rates.

In another version, the figure is computed based on the original capital cost or the acquisition cost of a property.

Capitalization Rate = Net Operating Income / Purchase Price

However, the second version is not very popular for two reasons. First, it gives unrealistic results for old properties that were purchased several years/decades ago at low prices, and second, it cannot be applied to the inherited property as their purchase price is zero making the division impossible.

Additionally, since property prices fluctuate widely, the first version using the current market price is a more accurate representation as compared to the second one which uses the fixed value original purchase price.

## Examples of Capitalization Rate

Assume that an investor has $1 million and he is considering investing in one of the two available investment options – one, he can invest in government-issued treasury bonds that offer a nominal 3 percent annual interest and are considered the safest investments and two, he can purchase a commercial building that has multiple tenants who are expected to pay regular rent. In the second case, assume that the total rent received per year is$90,000 and the investor needs to pay a total of $20,000 towards various maintenance costs and property taxes. It leaves the net income from the property investment at$70,000. Assume that during the first year, the property value remains steady at the original buy price of $1 million. The capitalization rate will be computed as (Net Operating Income/Property Value) =$70,000/$1 million = 7%. This return of 7 percent generated from the property investment fares better than the standard return of 3 percent available from the risk-free treasury bonds. The extra 4 percent represents the return for the risk taken by the investor by investing in the property market as against investing in the safest treasury bonds which come with zero risk. Property investment is risky, and there can be several scenarios where the return, as represented by the capitalization rate measure, can vary widely. For instance, a few of the tenants may move out and the rental income from the property may diminish to$40,000. Reducing the $20,000 towards various maintenance costs and property taxes, and assuming that property value stays at$1 million, the capitalization rate comes to ($20,000 /$1 million) = 2%. This value is less than the return available from risk-free bonds.

In another scenario, assume that the rental income stays at the original $90,000, but the maintenance cost and/or the property tax increases significantly, to say$50,000. The capitalization rate will then be ($40,000/$1 million) = 4%.

### Compete Risk Free with \$100,000 in Virtual Cash

Put your trading skills to the test with our FREE Stock Simulator. Compete with thousands of Investopedia traders and trade your way to the top! Submit trades in a virtual environment before you start risking your own money. Practice trading strategies so that when you’re ready to enter the real market, you’ve had the practice you need. Try our Stock Simulator today >>

« Back to Glossary Index