The capitalization rate, or “cap rate,” is one of the most fundamental metrics used to assess the value and return potential of a commercial real estate investment. It provides a snapshot of a property’s yield in a single percentage, facilitating quick comparisons across different assets and markets.

The Cap Rate Formula

The standard formula for calculating cap rate is:

Cap Rate = Net Operating Income (NOI) / Current Market Value (or Purchase Price)

Net Operating Income (NOI): This is the property’s annual income generated from rents and other sources, minus all operational expenses. It is critical to note that NOI excludes mortgage payments and capital expenditures.

Current Market Value: This is the property’s value on the open market, often reflected by its asking or purchase price.

Example Calculation:

Consider an apartment building with the following annual figures:

Gross Rental Income: $500,000

Operating Expenses (property taxes, insurance, maintenance, management fees): $200,000

Net Operating Income (NOI): $500,000 – $200,000 = $300,000

The property is listed for sale at $4,000,000.

Cap Rate = $300,000 / $4,000,000 = 0.075 or 7.5%

This 7.5% cap rate represents the projected annual return on an all-cash purchase…

Now you know how to determine your cap rate!