A cap rate is calculated as a mathematical relationship between net operating income and the property sale price.
Let’s take an example of how a cap rate is commonly used. Suppose we are researching the recent sale of a multi-family building with a Net Operating Income (NOI) of $125,000 and a sale price of $2,000,000. This property would have a 6.25% cap rate.
Capitalization rates, or cap rates, provide a tool for investors to use for valuing a property based on its Net Operating Income. For example, if a real estate investment provides $160,000 a year in Net Operating Income and similar properties have sold based on 8% cap rates, the subject property can be roughly valued at $2,000,000 because $160,000 divided by 8% (0.08) equals $2,000,000. A comparatively lower cap rate for a property would indicate less risk associated with the investment (increasing demand for the product), and a comparatively higher cap rate for a property might indicate more risk (reduced demand for the product). Some factors considered in assessing risk include creditworthiness of a tenant, term of lease, quality and location of property and general volatility of the market.