How To Compute Cap Rate:Definition and Formula

Capitalization rate (or cap rate) is a rate of return used in real estate investing to determine the present value of a real estate investment based upon its future benefits. Cap rate alone does not provide a complete picture of a property’s profitability, but because it provides a quick first-glance look at a property’s ability to pay its own way, it is one of the most popular returns used for real estate investing analysis. Real estate agents, appraisers, investors, property tax assessors, and others that evaluate real estate investment property typically all use cap rate in one form or the other.

How cap rate is used for real estate investing

In practice, you’ll use capitalization rate to express the relationship between a property’s value and its net operating income for the current or coming year.

As a result, you can use the cap rate formula to achieve three useful purposes:

  1. You can compute a property’s cap rate. When you want to know the cap rate for—as an example—a recently sold property, you would use that property’s net operating income and sale price to determine the cap rate it sold for.
  2. You can transpose the formula and compute a property’s estimated value. In preparation for a listing presentation, for instance, you can use the net operating income you estimate for that property and the cap rate for a similar, recently sold property to suggest a price.
  3. You can transpose the formula again and compute a property’s net operating income. In cases where you are given a specified price and cap rate, you can determine what the net operating income should be.

 Here are the formulas:

  1. Cap Rate = Net Operating Income (NOI) / Property Value
  2. Property Value = Net Operating Income / Cap Rate
  3. Net Operating Income = Property Value x Cap Rate

Understanding the role of net operating income (NOI)

Net operating income is one of the most important calculations one can make concerning any real estate investment. It is also the key to the cap rate formulations, and it is therefore crucial that you understand net operating income and the role it plays in making capitalization rate such a popular real estate investing return.

Mathematically, net operating income is a property’s gross operating income less the sum of all operating expenses. Why is it important? Net operating income represents the amount of money available to make the mortgage payment. Cap rate then measures the ratio between the money available for loan payment and sale price—essentially revealing whether a real estate investment will pay its own way—and this is why real estate investors and banks typically compute it.

To calculate net operating income correctly, though, one must be clear about the operating expenses. Be sure to include everything considered an operating expense, such as property taxes and repairs and maintenance, but avoid adding what are not true operating expenses like loan payments and depreciation.

If you are not sure about correctly calculating net operating income, befriend a real estate specialist or purchase a quality real estate investment software or real estate investor software solution that will help you do it correctly.


Here are a few parting words about capitalization rate you might find useful:

There is no such thing as a universal capitalization rate—it entirely depends on individual market areas. What might make a rental income property a steal in one city or state at a 5 percent cap rate, might not get a second look in another.

Cap rate can provide an assessment and comparison of investment properties, but you should never rely on cap rate alone when assessing a property’s profitability. You should always compute all relevant numbers, rates of return and cash flow scenarios.

Remember that numbers can be manipulated. When you are being told how great a buy an income property is based upon its cap rate, be sure to reconstruct your own raw data to insure that all is revealed and nothing is concealed before you actively pursue the real estate investment further.

Expect to find capitalization rate in an APOD. Quality real estate investing software solutions will calculate it here, and now that you understand what it means for real estate investing purposes, you should begin to look for it.

James R Kobzeff is the developer of ProAPOD Real Estate Investment Software. Create rental property cash flow, rates of return, and profitability analysis presentations in minutes. See how at

Related Posts

No related posts.