Full Definition
Capitalization rate (cap rate) is calculated as Net Operating Income (NOI) divided by the property's purchase price or current market value. It represents the unlevered yield of the property — what you'd earn annually if you paid 100% cash. Cap rates move inversely to price: as cap rates compress (go down), prices rise; as cap rates expand (go up), prices fall.
Example
A property with $120,000 annual NOI selling at a 6% cap rate is priced at $2,000,000. Same NOI at a 5% cap rate implies $2,400,000. Same NOI at a 7% cap rate implies $1,714,000.
Why It Matters
Cap rate is the most widely used CRE valuation metric. It standardizes pricing across different NOI levels, letting investors compare assets apples-to-apples.
Related Terms
NOI (Net Operating Income)
Annual income from a property after deducting operating expenses — before debt service, taxes, and capital expenditures.
Cash-on-Cash Return
Annual pre-tax cash flow divided by total cash invested. The levered return on your actual equity.
IRR (Internal Rate of Return)
The annualized rate of return over an investment's hold period, accounting for timing of all cash flows including sale proceeds.
Yield on Cost
For development deals: stabilized NOI divided by total development cost. The development spread vs. market cap rate.