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# Capitalization Rates (Cap Rates) in Commercial Real Estate

The capitalization rate, or cap rate, is calculated by dividing the net operating income of a property by its market value. This is the key tool appraisers use to determine the value of a commercial property and is the key metric behind the income capitalization approach to valuation.

## What are Cap Rates in Commercial Real Estate Finance?

The Cap Rate, otherwise known as the Capitalization Rate, is the expected return on investment on a commercial property. The Cap Rate is calculated by dividing the net operating income of a property by its market value. This is the key tool appraisers use to determine the value of a commercial property and is the key metric behind the income capitalization approach to valuation.

### How Do You Calculate a Cap Rate?

For example, a property with a NOI: Net Operating Income of $500,000 and a market value of $5,000,000 would have a capitalization rate of 10 %. Working it backwards, if you know a commercial property’s net operating income and at what cap rates similar properties (commercial properties of similar vintage and asset class) are trading for in that sub-market, you can use that relationship between the NOI and the capitalization rate, to determine the property value.

In this particular example, $500,000 (NOI) divided by 10% (cap rate) = $5,000,000. In an environment with compressed or lower cap rates, s property's value becomes inflated. For example, if that same property existed in a market where cap rates were at 5%, then $500,000 divided by 5% = $10,000,000.

In this capacity the income capitalization approach drives commercial property valuation since it's historically held as an alternative asset class. It also hedges against inflation by large funds and institutions.

### Cap Rate Calculator

Calculate your property's cap rate with our capitalization rate calculator.

## Related Questions

### What is a capitalization rate in commercial real estate?

The Cap Rate, otherwise known as the Capitalization Rate, is the expected return on investment on a commercial property. The Cap Rate is calculated by dividing the net operating income of a property by its market value. This is the key tool appraisers use to determine the value of a commercial property and is the key metric behind the income capitalization approach to valuation.

For example, a property with a NOI: Net Operating Income of $500,000 and a market value of $5,000,000 would have a capitalization rate of 10 %. Working it backwards, if you know a commercial property’s net operating income and at what cap rates similar properties (commercial properties of similar vintage and asset class) are trading for in that sub-market, you can use that relationship between the NOI and the capitalization rate, to determine the property value.

In this particular example, $500,000 (NOI) divided by 10% (cap rate) = $5,000,000. In an environment with compressed or lower cap rates, s property's value becomes inflated. For example, if that same property existed in a market where cap rates were at 5%, then $500,000 divided by 5% = $10,000,000. In this capacity the income capitalization approach definitely drives commercial property valuation since it's historically held as an alternative asset class. It also hedges against inflation by large funds and institutions.

### What factors affect capitalization rates in commercial real estate?

The Cap Rate, otherwise known as the Capitalization Rate, is the expected return on investment on a commercial property. The Cap Rate is calculated by dividing the net operating income of a property by its market value. This is the key tool appraisers use to determine the value of a commercial property and is the key metric behind the income capitalization approach to valuation.

How Do Interest Rates Impact Cap Rates? Not everyone agrees that there’s a direct causal link, but multifamily capitalization rates tend to increase as the cost of capital increases. It makes sense when you think about it: If borrowing becomes more expensive, this will necessarily impact property values. If a property’s value decreases with all other factors held the same — rents, operational costs, and so on — the cap rate will increase for that investment.

In summary, the factors that affect capitalization rates in commercial real estate are the net operating income of the property, the market value of the property, and the cost of capital.

### How is the capitalization rate used to evaluate commercial real estate investments?

For example, a property with a NOI: Net Operating Income of $500,000 and a market value of $5,000,000 would have a capitalization rate of 10 %. Working it backwards, if you know a commercial property’s net operating income and at what cap rates similar properties (commercial properties of similar vintage and asset class) are trading for in that sub-market, you can use that relationship between the NOI and the capitalization rate, to determine the property value.

In this particular example, $500,000 (NOI) divided by 10% (cap rate) = $5,000,000. In an environment with compressed or lower cap rates, s property's value becomes inflated. For example, if that same property existed in a market where cap rates were at 5%, then $500,000 divided by 5% = $10,000,000. In this capacity the income capitalization approach definitely drives commercial property valuation since it's historically held as an alternative asset class. It also hedges against inflation by large funds and institutions.

The capitalization rate is used to evaluate commercial real estate investments by providing an indication of the expected return on investment. By dividing the net operating income of a property by its market value, investors can determine the expected return on their investment. This is especially useful when comparing similar properties in the same sub-market, as the cap rate can be used to determine the relative value of each property.

### What is the difference between a capitalization rate and an internal rate of return?

The capitalization rate (or cap rate) is a metric used to measure the rate of return on a real estate investment property based on the expected income that the property will generate. It is calculated by dividing the net operating income (NOI) by the purchase price of the property. The internal rate of return (IRR) is a metric used to measure the rate of return on an investment over its entire lifespan. It is calculated by taking into account the time value of money and is often used by investors that have sensitivity to velocity of capital such as merchant builders.

### What is the average capitalization rate for commercial real estate investments?

The average capitalization rate for commercial real estate investments varies depending on the asset class, sub-market, and vintage of the property. Generally, cap rates range from 5-10%. For example, a property with a Net Operating Income (NOI) of $500,000 and a market value of $5,000,000 would have a capitalization rate of 10%.

You can use the relationship between the NOI and the capitalization rate to determine the property value. For example, if the same property existed in a market where cap rates were at 5%, then $500,000 divided by 5% = $10,000,000.

For more information, please visit Investopedia's Return on Investment page and Investopedia's Net Operating Income page.