Capitalization rate (or cap rate) is a rate of return used in real estate investing to determine the present value of a real estate investment based upon its future benefits. Cap rate alone does not provide a complete picture of a property's profitability, but because it provides a quick first-glance look at a property's ability to pay its own way, it is one of the most popular returns used for real estate investing analysis. Real estate agents, appraisers, investors, property tax assessors, and others that evaluate real estate investment property typically all use cap rate in one form or the other.

How cap rate is used for real estate investing

In practice, you'll use capitalization rate to express the relationship between a property's value and its net operating income for the current or coming year.

As a result, you can use the cap rate formula to achieve three useful purposes:

You can compute a property's cap rate. When you want to know the cap rate for—as an example—a recently sold property, you would use that property's net operating income and sale price to determine the cap rate it sold for.
You can transpose the formula and compute a property's estimated value. In preparation for a listing presentation, for instance, you can use the net operating income you estimate for that property and the cap rate for a similar, recently sold property to suggest a price.
You can transpose the formula again and compute a property's net operating income. In cases where you are given a specified price and cap rate, you can determine what the net operating income should be.

Here are the formulas:

Cap Rate = Net Operating Income (NOI) / Property Value
Property Value = Net Operating Income / Cap Rate
Net Operating Income = Property Value x Cap Rate

Understanding the role of net operating income (NOI)

Net operating income is one of the most important calculations one can make concerning any real estate investment. It is also the key to the cap rate formulations, and it is therefore crucial that you understand net operating income and the role it plays in making capitalization rate such a popular real estate investing return.

Mathematically, net operating income is a property's gross operating income less the sum of all operating expenses. Why is it important? Net operating income represents the amount of money available to make the mortgage payment. Cap rate then measures the ratio between the money a...

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