The capitalization rate-or cap rate-calculates the rate of return from an investment based on the current or projected net operating income divided by the property value or price.
The cap rate calculation should only be used to compare similar properties in the same market for two reasons:
First, income and property prices vary between asset classes – such as residential rental property versus office buildings. Second, cap rates vary by location for the same property type due to factors such as: supply and demand, people working from home, and real estate prices in general.
The cap rate formula divides the net operating income (NOI) that a property generates before debt service (P&I) by the property value.
Debt such as a mortgage payment is excluded from the cap rate calculation to make an apples-to-apples comparison because investors will use different degrees of leverage.
To find the cap rate, first determine the net operating income. This is usually done by using the 50% rule to subtract operating expenses from the gross annual rental income. A property gross income of $18,000 per year means the NOI will be $9,000 per year.
If the property has an asking price of $120,000 the projected cap rate will be 7.5%:
$9,000 NOI /$120,000 Property Price = 0.075 or 7.5%
When comparing two more similar properties in the same market to invest in, the property with the highest cap rate will be the better investment because the potential return is higher, everything else being equal.