Cap Rate - A Deeper Dive

The capitalization rate (just called the "cap rate") is the most basic metric in the real estate industry. The definition of the cap rate is the ratio of net operating income (NOI) to the property's value.

Cap Rate = Property Net Operating Income / Property Value

The best way to think about the cap rate is that it represents the percentage return an investor would receive on an all cash purchase, similar to the coupon rate on a bond. Similar to a bond, the cap rate is inversely related to the price of the asset. The higher the price, the lower the cap rate.​

The cap rate provides a great way to quickly determine how relatively expensive an asset is. In fact, whenever you ask a broker how much a property is selling for, they'll most likely say it is selling for an X.X% cap rate instead of quoting an actual dollar amount.

There are many variables that affect the cap rate. For instance, a fully leased building will have a lower cap rate than a partially vacant building. Why? Because the fully leased building's cash flows are more certain and therefore the property is less risky. In general, the following items will lower the cap rate:

• Real estate located in a strong, growing market with low vacancy
• Higher quality building
• Fully occupied building
• Strong, credit tenant
• Long lease term

You will note that each of these items lowers the "risk" of the investment.

Check out our Real Estate Career Guide for even more information on cap rate and other real estate metrics!