The capitalization (cap) rate measures the expected rate of return on an investment property, expressed as a percentage of the property’s value. The cap rate is often used by real estate investors to evaluate potential investments and determine the value of a property.
Here’s the formula for calculating the cap rate:
(Net Operating Income / Property Value) x 100 = Cap Rate
“Net Operating Income” is defined as the rental income from the property minus operating expenses such as property taxes, insurance, maintenance, property management fees, and common charges (for condos).
For example, if a property has a rental income of $75,000 per year and operating expenses of $25,000 per year, the net operating income would be $50,000. If the property value is $1,000,000, the cap rate would be:
($50,000 / $1,000,000) x 100 = 5%
The cap rate provides a quick and simple way to compare the expected return on different properties, as well as to estimate the value of a property based on its expected income. A higher cap rate indicates a higher expected return on investment, while a lower cap rate suggests a lower return.