How is the capitalization rate calculated?

The capitalization rate, commonly known as the cap rate, is a key metric used in real estate to assess the profitability and potential return on an investment property. It is calculated by dividing the net operating income (NOI) of a property by its sales price or current market value.

This method highlights the relationship between the income generated by the property and the amount of investment made to acquire it. The net operating income represents the income generated from the property after deducting all operational expenses, but before financing costs and taxes are considered. By expressing this income as a percentage of the sales price, investors can evaluate the expected return on an investment and compare it with other potential investments.

For instance, if a property generates a net operating income of $100,000 and has a sales price of $1,000,000, the cap rate would be 10% ($100,000 ÷ $1,000,000). A higher cap rate typically indicates a higher potential return, reflecting a greater risk or a lesser-quality investment, while a lower cap rate suggests a lower risk with potentially lower returns.

In summary, dividing the net operating income by the sales price provides a percentage that serves as an essential reference for investors when determining the value and viability of an