The Capitalization Rate, commonly known as Cap Rate, is a key metric used in commercial real estate to estimate the potential return on an investment property. It's calculated by dividing the property's Net Operating Income (NOI) by its current market value or purchase price. The Cap Rate provides a simplified, quick way to compare the profitability of different income-generating properties.
What is Net Operating Income (NOI)?
Net Operating Income (NOI) represents the annual income a property generates after deducting all operating expenses, but before accounting for debt service (mortgage payments) and income taxes. A typical calculation for NOI is:
Gross Rental Income: The total potential rental income from the property.
Minus: Vacancy and Credit Losses: An allowance for periods when units are vacant or tenants default.
Equals: Effective Gross Income (EGI).
Minus: Operating Expenses: Costs like property taxes, insurance, property management fees, repairs and maintenance, utilities (if paid by owner), and administrative costs.
Equals: Net Operating Income (NOI).
Crucially, NOI does NOT include mortgage principal and interest payments, depreciation, capital expenditures (major improvements), or income taxes. It focuses purely on the property's operational profitability.
How to Calculate Cap Rate
The formula for calculating Cap Rate is straightforward:
Cap Rate = (Net Operating Income / Property Value) * 100%
In our calculator, you provide the Net Operating Income (NOI) and the Property Value. The calculator then applies this formula to give you the Cap Rate as a percentage.
Interpreting the Cap Rate
A higher Cap Rate generally suggests a higher potential return on investment, indicating that the property might be a better value or that it carries higher risk. Conversely, a lower Cap Rate might indicate a more stable, less risky investment with lower immediate returns, or that the property is potentially overpriced.
Higher Cap Rate: Often seen in riskier markets or property types, or when the property is acquired at a lower price relative to its income.
Lower Cap Rate: Typically associated with stable, prime markets, high-demand areas, or premium properties where investors are willing to accept a lower yield for security and potential appreciation.
Cap Rate is a useful tool for initial property assessment and comparison, but it's essential to consider other factors such as market conditions, property condition, lease terms, and potential for future growth when making investment decisions.
Example Calculation
Let's say you are considering a commercial building with the following: