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


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


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.


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.









The surplus return, which is theoretically available to property investors over and above the treasury bond investments, can be attributed to the associated risks that lead to the above-mentioned scenarios. The risk factors include:

  • Age, location, and status of the property
  • Tenants’ solvency and regular receipts of rentals
  • Term and structure of tenant lease(s)
  • The overall market rate of the property and the factors affecting its valuation

Interpreting the Capitalization Rate





It indicates that a lower value of cap rate corresponds to better valuation and a better prospect of returns with a lower level of risk. On the other hand, a higher value of cap rate implies relatively lower prospects of return on property investment, and hence a higher level of risk.

While the above hypothetical example makes it an easy choice for an investor to go with the property in the city center, real-world scenarios may not be that straightforward. The investor assessing a property on the basis of cap rate faces the challenging task to determine the suitable cap rate for a given level of the risk.


Capitalization Rate

Gordon Model Representation for Cap Rate



Rearranging the equation and generalizing the formula beyond dividend,


The above representation matches the basic formula of capitalization rate mentioned in the earlier section. The expected cash flow value represents the net operating income and the asset value matches with the current market price of the property. This leads to the capitalization rate being equivalent to the difference between the required rate of return and the expected growth rate. That is, the cap rate is simply the required rate of return minus the growth rate.
