Investment Math
Capitalization Rate (Cap Rate): Real Estate Exam Math Explained
Capitalization rate (cap rate) measures a property's return on investment based on income. Cap Rate = Net Operating Income (NOI) ÷ Property Value × 100. It's how investors compare income properties and how appraisers can value income property using the income approach.
The Formula
Cap Rate (%) = Net Operating Income (NOI) ÷ Property Value × 100. NOI = Gross Income − Operating Expenses (excluding mortgage payments and income taxes).
Rearranging: Property Value = NOI ÷ Cap Rate. This is how appraisers value income property using the income approach.
Three Worked Examples
Question 1
A property has annual gross rental income of $120,000 and operating expenses of $42,000. The property is valued at $1,000,000. What's the cap rate?
NOI = $120,000 − $42,000 = $78,000. Cap rate = $78,000 ÷ $1,000,000 × 100 = 7.8%.
Question 2
A market cap rate is 6%. A property has NOI of $90,000. What's the property's value using the income approach?
Value = NOI ÷ Cap Rate = $90,000 ÷ 0.06 = $1,500,000.
Question 3
An investor wants a 7% cap rate. The property they're considering has NOI of $84,000. What's the maximum price they should offer?
Max price = $84,000 ÷ 0.07 = $1,200,000.
What Cap Rates Mean
Higher cap rate = higher return but typically higher risk (or less desirable location)
Lower cap rate = lower return but typically lower risk (premium location/quality)
Cap rates compress in hot markets and expand when buyers demand higher returns
5–8% is typical for stabilized commercial in major U.S. metros
Cap rate doesn't include financing costs — it measures property-level returns only
Practice Investment Math
Drill cap rate and other investment math problems.
Related Concepts
Cap Rate FAQ
Why exclude financing from cap rate?
Cap rate measures property-level returns. Financing terms vary by buyer. By excluding mortgage costs, cap rate makes properties comparable across different financing structures.
What's NOI?
Net Operating Income — gross income minus operating expenses (taxes, insurance, maintenance, management). Excludes mortgage payments, income taxes, and capital expenditures.
What's the relationship between cap rate and value?
Inverse. As cap rates compress (decrease), property values rise. As cap rates expand (increase), property values fall.