Investment Math
Capitalization Rate (Cap Rate) Explained
The capitalization rate is the most common metric for comparing income-producing properties. It appears on nearly every real estate exam and is essential for understanding investment property value.
The Cap Rate Formula
Cap Rate = Net Operating Income (NOI) ÷ Property Value
NOI is gross rental income minus operating expenses (taxes, insurance, maintenance, management). NOI does NOT include mortgage payments — cap rate is calculated before debt service.
The formula works in reverse too: Property Value = NOI ÷ Cap Rate. If a property has an NOI of $50,000 and comparable properties trade at a 5% cap rate, the indicated value is $50,000 ÷ 0.05 = $1,000,000.
Practice Questions
Question 1
A property has gross rents of $80,000/year and operating expenses of $30,000. If similar properties sell at a 6% cap rate, what is the indicated value? (A) $500,000 (B) $750,000 (C) $833,333 (D) $1,333,333
C — NOI = $80,000 − $30,000 = $50,000. Value = $50,000 ÷ 0.06 = $833,333.
Question 2
An investor pays $600,000 for a property with an NOI of $42,000. What is the cap rate? (A) 5% (B) 6% (C) 7% (D) 8%
C — Cap Rate = $42,000 ÷ $600,000 = 0.07 = 7%.
Cap Rate FAQ
What is a 'good' cap rate?
It depends on the market and property type. Class A apartments in major metros may trade at 4–5% cap rates. Class C properties in secondary markets may trade at 8–10%. Higher cap rate = higher yield but typically more risk or lower quality.
Does cap rate include mortgage payments?
No. Cap rate is calculated using NOI before debt service. This makes cap rate a property-level metric, not affected by financing decisions. Cash-on-cash return accounts for financing.
What is Net Operating Income (NOI)?
NOI = Gross Rental Income - Vacancy & Credit Loss - Operating Expenses. It does NOT subtract mortgage payments, income taxes, or depreciation.
If cap rates rise, what happens to property values?
If cap rates rise and NOI stays constant, property values fall (Value = NOI ÷ Cap Rate). Rising cap rates compress values — this is why interest rate increases typically push real estate values down.