Capitalization rate

Before you rely on it

What to check

Check that the net operating income behind it uses realistic vacancy, management and maintenance figures.

The common error

Where people go wrong with capitalization rate

Accepting a seller's NOI. Cap rate computed from an optimistic income figure is arithmetic wearing the costume of analysis, and the number that comes out is exactly as good as the assumptions fed in.

Worked through

Capitalization rate in plain numbers

A building earns $60,000 a year in net operating income after operating costs and before any mortgage; it is priced at $1,000,000. The cap rate is 60,000 ÷ 1,000,000, or 6%. If comparable buildings in that area trade at 7%, the same income would support a value of 60,000 ÷ 0.07, about $857,000. So a small shift in the market's required rate has a large effect on price. If the owner raises net income by $6,000 through better management, then at a 6% cap rate the value rises by $100,000. Income and rate both drive value.

Easily confused

Capitalization rate and its neighbours

The cap rate is not a mortgage rate and not a total return; it ignores financing entirely, so it compares properties without a loan. It also differs from cash-on-cash return, which uses the cash invested and the cash flow after debt service; the gross rent multiplier uses gross rent instead of net operating income and ignores expenses. And a cap rate is not an internal rate of return: it is a single-year snapshot and does not include growth, taxes or the sale. Each metric answers a different question about the same property.

In real decisions

Where capitalization rate turns up

Investors and brokers use cap rates to compare properties and to estimate value from income. Appraisers apply market cap rates to a property's net operating income; lenders look at cap rates when judging whether a purchase price is reasonable; a lower rate usually signals a lower perceived risk or higher expected growth, and a higher rate signals the opposite. Tracking local cap rates over time shows how the market is pricing risk. It is often the first number quoted in a commercial deal.

Know the edges

Where capitalization rate stops being reliable

Cap rate depends on how net operating income is defined, and sellers can flatter it with optimistic assumptions about vacancy or expenses; it ignores capital expenditures, financing and taxes. Two properties with the same cap rate can have different growth and risk. Market rates change, so a stale comparison can mislead. Use it for a quick comparison and then dig into the real numbers behind the income, including leases, tenants and the condition of the building.

Quick answers

What people ask about capitalization rate

What is a good cap rate? There is no universal answer. Cap rates vary by city, property type, age and lease quality. Higher rates usually go with higher risk. Compare with similar properties sold nearby.

Do cap rates include the mortgage? No. They use net operating income before debt service, so the same building has one cap rate whatever the financing.