The capitalization rate (cap rate) is a metric used to value commercial real estate investments. The ratio of the annual net operating income to the original cost of the property determines the cap rate. Importantly, it’s the key component of the income capitalization approach to arriving at an appraisal.
Capitalization Rate Formula
To calculate the cap rate, use this equation:
cap rate = annual net operating income ÷ cost
Annual net operating income is the portion of the year’s lease income that isn’t going toward operating expenses, mortgage payments, taxes or any other costs.
With the equation expressed this way, cost usually refers to the purchase price. However, most people interested in a cap rate are solving for cost rather than the cap rate. Thus, they render the formula this way:
Cost = annual net operating income ÷ cap rate
In this case, the cost they’re solving for is actually the current market value of a property.
Cap Rate as a Valuation Tool
Take for example an office building that generates $1,000,000 in annual net operating income. It’s in a neighborhood where the cap rate for recent transactions has been 5%. In that case, the prospective seller could reasonably set the asking price at $20,000,000 — that is, $1,000,000 divided by 0.05.
Just like any other real estate valuation tool, the cap rate is only one point of information. A proper appraisal might include the income capitalization approach, which is the one that uses the cap rate. It might also include market comparisons, costs of acquiring and improving the property or discounted cash flow analysis.