Capitalization rate, or “cap” rate, is used to measure a commercial real estate investor’s potential rate of return based upon the expected cash flow the property will generate. This simple calculation is done in a one-year time frame and allows investors to compare a commercial property’s income relative to it’s price. It’s a quick method of determining whether a property is overvalued or undervalued.

Cap rate is calculated by dividing the Net Operating Income (income after fixed and variable operating costs) by the total value or sales price of the property.

Capitalization Rate = Net Operating Income/Value

When a market’s cap rate and a property’s cash flow are known, this formula makes determining a property’s value simple:

Net Operating Income/Cap Rate = Value

For example, let’s say an investor recently sold a multifamily complex that generated $2,000,000 in net operating income for $40,000,000. This property would have a 5% cap rate, or “5 cap”. Another investor with a similar property that generates $2,500,000 in net operating income might list his property for sale at $50,000,000 ($2,500,000/.05 = $50,000,000).

• This formula does not take into account any debt on the property.
• Given identical cash flows, lower cap rates will create higher valuations and higher cap rates will create lower valuations.
• Cap rates are not the sole indication of an investment’s strength because they do not take int account any debt on the property, future cash flows from property improvements, the time value of money, and other factors.

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