Capitalization Rate

The Capitalization Rate or Cap Rate is a formula used to calculate the value of income producing properties. Put simply, the cap rate is the net operating income divided by the sales price or value of a property. 

Another way to look at this is if you paid cash for the property the “Cap Rate” is your rate of return on your investment. The cap rate does not include any calculation for the appreciation of a property. Investors, lenders and appraisers use the cap rate to estimate the purchase price for different types of properties.

The Cap Rate calculation incorporates a property's selling price, gross rents, non rental income, vacancy amount and operating expenses thus providing a more reliable estimate of value.

If we have a seller and an interested buyer for particular piece of income property, the seller is trying to get the highest price for the property or sell at the lowest cap rate possible. The buyer is trying to purchase the property at the lowest price possible which translates into a higher cap rate. The lower the selling price the higher the cap rate. The higher the selling price, the lower the cap rate. In summary, from an investors or buyers perspective, the higher the cap rate, the better.