# Capitalization Rate

A cap rate is a commercial financing measure representative of the expected net gain or loss of profit on an investment over a specified time period, usually one year.

## What Is a Cap Rate?

A capitalization rate, more often known as a cap rate, is a commercial financing metric indicating the rate of return on an investment over one year. Aside from being useful for commercial real estate investors, cap rates are also important for appraisers. Property appraisers use them to determine the value of properties like self-storage facilities. Cap rates are, after all, the key metric in assessing an income-producing asset’s profitability.

### Calculating Your Cap Rate

To calculate a cap rate, you must first determine the market value and net operating income of the asset. Once you have those figures, the formula is simple. Just calculate the asset's annual net operating income by its current market value. The resulting percentage is your cap rate.

#### Cap Rate Formula

**Cap Rate = Net Operating Income ÷ Current Market Value**

Let's use an example. Imagine a self-storage facility with an annual net operating income of $450,000 and a market value of $5 million. This property would have a capitalization rate of 9%.

**$450,000 ÷ $5 million = 9%**

#### Cap Rate Calculator

## What Is a Good Cap Rate?

The capitalization rate reflects projected estimates of future income — which makes its interpretation wholly up to the person inquiring. As such, an investor should decide what constitutes a good cap rate for each individual investment opportunity. As for financing a commercial asset, there are no industry-defined specifications for a good or bad cap rate. Even so, a higher cap rate is typically indicative of a higher net operating income and a lower valuation, and the opposite is true for a lower cap rate. These insights can help investors understand the level of risk presented by a given investment opportunity.

## Shortcomings of Cap Rates

While cap rates are commonly used in commercial real estate investment, they are not perfect measures. First, cap rates rely upon future net operating income. If some tenants end leases at your self-storage facility, the calculation will be inaccurate. Incorrectly calculating your vacancy costs or other property income can also throw off the figure significantly.

Second, the time value of money does not enter into the calculation. If you plan to hold an asset for a long-term period, the one-year time frame of the calculation can be limiting and misleading.

Finally, cap rate calculations do not include the costs of debt service. The cost of financing can be significant, particularly if your loan is at a high loan-to-value ratio.

Despite the shortcomings, cap rates can be very useful — but investors should not solely rely on them to make a decision. Instead, utilize other metrics like a property’s return on investment or internal rate of return.

## Related Questions

### What is a capitalization rate?

A capitalization rate, or cap rate, is a value that compares different real estate investments. It is calculated by dividing the net operating income of a property by its market value, and is expressed as a percentage. This metric is used in multifamily financing to determine the annual net gain or loss of profit on an investment that is expected to be generated on an apartment property.

### How is a capitalization rate calculated?

The capitalization rate can be found by dividing an asset’s net operating income by its current market value. To better understand how to calculate cap rate, imagine a property with a net operating income of $500,000 at a market value of $5,000,000. This property would have a capitalization rate of 10%.

The capitalization rate can be determined by utilizing the following formula:

Capitalization Rate = Net Operating Income ÷ Current Market Value ### What factors influence a capitalization rate?

Cap rate is the most widely utilized calculation through which investors and lenders can assess the profitability and return potential on an apartment property investment. Factors that influence a capitalization rate include the property's Net Operating Income (NOI), the cost of capital, leverage, the time value of money, and future cash flows from property improvements. Additionally, the cap rate of a property is also dependent on the context of the property and the market it resides in.

For more information, please see this article and this calculator.

### What is the difference between a capitalization rate and an interest rate?

The capitalization rate (or cap rate) is a value that compares different real estate investments and is calculated by dividing the net operating income of a property by its market value. This is the key tool appraisers use to determine the value of a commercial property and is the key metric behind the income capitalization approach to valuation. An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. Interest rates are typically expressed as a percentage of the principal loan amount.

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### What is a good capitalization rate for commercial real estate?

Generally, a cap rate of 8-10% is considered a good cap rate for a rental property. However, cap rates can vary significantly depending on the market and the type of property. For example, a cap rate of 6-7% may be considered good for a multifamily property in a high-demand market.

You can learn more about Capitalization Rates (Cap Rates) in Commercial Real Estate and calculate your cap rate with our calculator.

### How does a capitalization rate affect the value of a property?

Capitalization rates (cap rates) are used to determine the value of a property. When the cost of capital increases, the value of the property decreases, and the cap rate increases. This is because if the borrowing costs become more expensive, the value of the property will decrease. To calculate the cap rate, you need to know the property's Net Operating Income (NOI) and the market value of the property. The formula for calculating the cap rate is NOI divided by the cap rate, which will give you the property value. For example, if a property has an NOI of $500,000 and a market value of $5,000,000, the cap rate would be 10%. This means that if the cap rate is 5%, the property value would be $10,000,000. This shows that when the cap rate is lower, the property value is inflated.

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