A Capitalization Rate, or “Cap Rate” is a tool commonly used in the commercial real estate industry to quickly determine the rate of return on a real estate investment property. The Cap Rate is determined by dividing the income the property will generate (after fixed costs and variable costs) by the total value of the property. In formula, the Cap Rate is expressed as follows:
Net Operating Income (NOI)/Total Value (or cost) = Cap Rate
$100,000 (NOI)/$1,000,000 Sales Price = 10% Cap Rate
Another way of thinking about the Cap Rate (using the example above) is that one-tenth of the building’s cost is paid by the year’s net proceeds.
Remember that calculation of the Net Operating Income (NOI), does not include debt services, depreciation or capital improvements.