What Is a Cap Rate?

A capitalization rate, more commonly known as a cap rate, is a commercial real estate finance metric that represents the net gain or loss of profit that is expected to be generated on an investment property. The metric is measured over a specified time period — typically a year.

Cap Rate Calculator

How To Calculate a Cap Rate

To determine the cap rate of an asset, divide the property’s net operating income (NOI) by its market value. The resulting figure, expressed as a percentage, is the capitalization rate of the property. The cap rate of an asset is often an important metric analyzed by appraisers in the determination of value of a commercial property. In fact, it’s actually the key metric behind the income capitalization approach to property valuation.

The cap rate can be determined using the following formula:
⁠Capitalization Rate = Net Operating Income ÷ Current Market Value or Purchase Price

To better understand how to calculate cap rate, imagine a commercial property with a net operating income of $750,000 at a market value of $10 million. This property would have a capitalization rate of 7.5%. 

Cap Rate = $750,000 ÷ $10,000,000 = 7.5%

The formula can also be used by substituting an investment property’s purchase price instead of using the current market value. Same formula can be used to calculate Cap Rate for a rental property. This can help investors determine the potential profitability of one asset compared to another.

Calculate the NOI for a Cap Rate

To calculate the NOI for a cap rate, you will need to take the following steps:

1. Determine the property's value
2. Subtract the mortgage balance from the property value
3. Subtract any vacancy and collection losses from the property's potential gross income
4. Subtract all operating expenses from the property's potential gross income
5. Subtract any debt service from the property's NOI

The result will be the property's NOI for a cap rate.
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⁠It's important to note that the NOI does not include any debt service, such as mortgage payments or interest. This is because the cap rate is intended to measure the property's profitability on an unlevered basis.

How to Use a Cap Rate

The measurement of an asset’s cap rate is arguably the most widely used method for lenders and investors to assess the profitability and return potential on a commercial real estate investment.

Cap rates can also be used as a good indicator of the potential length of time it will take an investor to recover a staked amount in an income-producing property.

As an example, consider a property with a cap rate of 10%. This metric reflects that it would take around 10 years for an investor to recover the full investment amount. An investment with a 5% cap rate would take around 20 years, and so on. Note that the eventual sale of an asset is not included in these calculations.

Additionally, the relationship between an asset’s NOI and its cap rate can be used to estimate the property’s value. An investor must have a good idea of the cap rates of similar properties — they should be commercial assets of similar vintage and class — as well as the prices they are trading for in that submarket.

6 Main Limitations of a Cap Rate Calculation

Though a simple and useful formula and metric, cap rates do have their drawbacks. Here are six limitations of this calculation. Note that despite these drawbacks, capitalization rates are still very useful to utilize for some aspects of your investment strategy — just don't rely exclusively on them.

1. It Has a Limited Scope

Cap rates only take into account a property's current NOI, which may not accurately reflect its potential future earnings. For example, if a property's vacancy is rather high, its current NOI may not reflect its potential to generate higher rental income in the future. Additionally, future increases in cash flows and the time value of money are not taken into consideration for cap rate calculations.

2. It Doesn't Consider Financing

Cap rates also do not consider financing costs, such as interest rates and loan terms. This means that two properties with the same cap rate may have vastly different returns for investors depending on their financing structure.

3. It Doesn't Consider Market Trends

Cap rates are based on market value, which can be influenced by factors such as supply and demand, economic conditions, and interest rates. As a result, cap rates may not accurately reflect market trends and may not be a reliable indicator of a property's future performance.

4. It Doesn't Consider Expenses

Cap rates do not take into account the operating expenses associated with running a property, such as maintenance and repair costs, property taxes, and insurance. This means that a property with a higher cap rate may actually generate lower returns for investors if it has higher operating expenses.

5. It Has Limited Comparative Uses

Cap rates can only be used to compare properties that are similar in terms of asset class, location, and size. This means that cap rates may not be applicable to all commercial real estate investments and may not provide accurate comparisons for properties that have unique characteristics.

6. It's Not Always Simple to Determine Market Value

If you acquired a property several years ago, don't base your cap rate off of the sale price. It will likely be misleading due to changing property values. This holds true for value-add purchases as well, given the infusion of extra capital outside of the sale price.

Similarly, don’t use a sale price for your cap rate calculation if it is a non-arm’s length deal, as this wouldn’t reflect market value. In these situations, it is much safer to use the current market value of the property.