Capitalization Rate (Cap Rate)
Also called: Cap rate, Going-in cap rate
A capitalization rate is a property's net operating income divided by its purchase price, expressed as a percentage, and it represents the unlevered annual yield the property produces at that price.
The cap rate is the single most quoted number in commercial real estate because it converts a price into a yield, which lets you compare a 24-unit building in Tucson against a 300-unit building in Atlanta on the same axis. A lower cap rate means a higher price for the same income, so cap rate and value move in opposite directions.
Cap rates are not a return you actually receive. They ignore debt, they ignore capital expenditures, and they describe a single year. They are a pricing convention, which is why two buyers can agree on the cap rate and still disagree on the value of a deal by a wide margin once financing and business plan are layered on.
The rate you buy at is the going-in cap rate. The rate you assume a future buyer pays you is the exit cap rate, and because it is applied to a much larger income stream at the end of the hold, it usually swings returns more than the going-in rate does.
How to calculate capitalization rate
Cap Rate = Net Operating Income / Purchase Price- Net Operating Income:
- Annual income after operating expenses, before debt service and capital expenditures
- Purchase Price:
- Contract price, generally excluding closing costs
Worked example
A 40-unit property under contract at $6,000,000:
- Net operating income
- $390,000
- Purchase price
- $6,000,000
- Calculation
- $390,000 / $6,000,000
Rules of thumb
- Always confirm whether a quoted cap rate uses trailing income, the seller's proforma, or your own underwritten income. Broker marketing usually uses the most flattering of the three.
- A cap rate is only comparable if the net operating income behind it includes a replacement reserve and a real management fee. Many offering memoranda omit both.
- Underwriting an exit cap rate at or above your going-in rate is the standard conservative convention, typically 25 to 50 basis points of expansion over a five year hold.
Calculate capitalization rate
Related terms
- Net Operating Income (NOI)
Net operating income is a property's effective gross income minus all operating expenses, excluding debt service, capital expenditures, depreciation, and income taxes.
- Exit Cap Rate
The exit cap rate is the capitalization rate assumed to apply when a property is sold at the end of the hold period, and it converts projected final-year net operating income into an assumed sale price.
- Price Per Unit
Price per unit is a property's total purchase price divided by its number of units, and it is the standard shorthand for comparing multifamily pricing across deals in a market.
- Debt Yield
Debt yield is net operating income divided by the total loan amount, measuring the unlevered return a lender would earn if it foreclosed and took the property back on day one.