Capitalization Rate (Cap Rate)

The Capitalization Rate (“Cap Rate”) is a ratio used to compare properties with different valuations, and to also place a value on a property based on the income it generates.  The Cap Rate is computed by taking the rental net operating income (NOI) and dividing it by the property's fair market value (FMV).  The higher the Capitalization Rate is the better.

Cap Rate - Practical Use #1

You can use the Cap Rate to value your property.   Let's say that your property generates $10,000 of annual net operating income.  Your real estate agent tells you that the Capitalization Rate in your area is approximately 4%.  That would mean that the approximate fair market value of your property is $250,000 ($10,000 / .04).

Cap Rate - Practical Use #2

Let's assume that you are looking at investing in two properties.  The first property has a projected NOI of $20,000 and an asking price of $500,000.  The second property has a NOI of only $10,000 but an asking price of $110,000.  Which one would the Cap Rate suggest is a better investment?  That's right, the second property since the Cap Rate is 9% ($10,000 / $110,000) versus 4% ($20,000 / $500,000).