However, it is just one of many metrics that can be used to assess the return on commercial real estate property. In a simple world, John may base his purchase on the rate alone.

John identifies three properties with their respective expenses, annual income, and market values:Īfter doing the calculations for the properties above, John realizes that Property C returns the highest cap rate. From taking real estate courses, he remembers that the capitalization rate is an effective metric in evaluating real estate properties. John is an investor looking to buy an investment property. On the contrary, the property located in the run-down part of the city would come with a higher cap, reflected by the lower market value of that asset. The property in the highly coveted suburban region would show a lower cap through the high market value of the asset. Therefore, there is no “optimal” cap rate – it depends on the investor’s risk preference.įor example, consider two properties in different geographical locations – one is in a highly coveted suburban region while the other is in a run-down part of the city. It is useful to note that different cap rates represent different levels of risk – a low cap rate implies lower risk while a high cap rate implies higher risk. For example, if a property comes with a 10% cap, it will take 10 years for the investor to recover his investment (called “fully capitalized”).Īlthough it’s an important metric in comparing investment opportunities, investors should never base a purchase on the cap rate of a property alone. The rate also indicates the amount of time it takes to recover an investment in a property. For example, if all else equal, a property with a 10% cap rate versus another property’s 3%, an investor is most likely to focus on the property with a 10% cap rate. The capitalization rate is used to compare different investment opportunities. Current market value of the asset is the value of an asset on the marketplace.

Net operating income is the annual income generated by the property after deducting all expenses that are incurred from operations including managing the property and paying taxes.

The formula for Cap Rate is equal to Net Operating Income (NOI) divided by the current market value of the asset. Learn more in CFI’s Real Estate Modeling Course. In other words, capitalization rate is a return metric that is used to determine the potential return on investment or payback of capital. Updated What is Capitalization Rate (Cap Rate)?Ĭapitalization rate (or Cap Rate for short) is commonly used in real estate and refers to the rate of return on a property based on the net operating income (NOI) that the property generates.

Noi calculation bigger pocket