What Is a Cap Rate? Capitalization Rate Explained

The simple definition

The capitalization rate, or cap rate, is the net operating income of a property divided by its price or value. It shows the yearly return you would earn if you paid cash for the property.

How to calculate it

Add up the rent you expect to collect in a year, subtract an allowance for vacancy, then subtract the running costs such as property tax, insurance, repairs, management and utilities the owner pays. The result is the net operating income. Divide it by the price.

Example: a building earns 180,000 dollars in rent, loses 5 percent to vacancy and costs 60,000 dollars a year to run. The income after vacancy is 171,000 dollars and the net operating income is 111,000 dollars. At a price of 1,500,000 dollars the cap rate is 7.4 percent.

What counts and what does not

Loan payments, depreciation and income tax are not part of net operating income. The cap rate looks at the property itself, before any loan.

What is a good cap rate?

There is no single good number. Higher cap rates usually come with more risk, such as weaker locations, shorter leases or older buildings. Lower cap rates usually belong to safer, higher quality properties. Compare a property with similar ones nearby and with the cost of borrowing.

Where the cap rate can mislead

It uses one year of income and ignores the loan, growth in rent, big repairs coming up and the cost of getting a new tenant. Always check the figures behind it and look at cash flow after the loan as well.