Capitalization Rate (Cap Rate)

A return metric used to estimate a property’s value based on its income potential. It is calculated by dividing the property’s net operating income by the present-day value of the property as indicated by prevailing market rates.

The cap rate is an important metric for real estate investors because it helps them compare different investment opportunities and assess the risks associated with those investments.

Expressed as a percentage, a higher cap rate suggests higher income and greater risk. However, cap rates do not account for every factor that can affect asset value. 

Cap rate compression occurs when cap rates fall as valuations rise, which is a positive for investors. Falling cap rates suggest rising prices for a stream of income, typically resulting in price appreciation and higher total returns.

Various factors impact cap rates, such as location, the available inventory in a particular market and market trends. For example, two similar buildings in different parts of a city—one in the city center and another on the outskirts—can have different cap rates. The city center building will generate higher rent, but that higher income will be balanced against higher maintenance costs and higher taxes. The city center building should have a lower cap rate due to its significantly high market value.