Short for capitalization rate, Cap Rate is one of the most widely used formulas by real estate investors when analyzing investment property. It’s a component of return on investment for an investment property as it relates to the Purchase Price and based on the amount of Annual Net Operating Income the property will yield (not including mortgage payments or considering income tax) in proportion to the purchase price of the property.

Cap Rate is calculated by taking the Annual Net Operating Income of the investment property and dividing it by the Purchase Price.

So, the Cap Rate formula is:

Cap Rate = Annual Net Operating Income (not including mortgage payments)/Purchase Price

Note: when calculating Cap Rate, a higher resulting number is better.

Cap Rate Example: Let’s say you purchase a property for $100,000 that produces an annual net operating income of $5,000; this property would have a Cap Rate of 5% (5,000/100,000). Based on this calculation the property will generate 5% of the purchase price in income (not considering income tax) per year. If you were looking at another property with a purchase price of $100,000 that produced an Annual Net Operating Income of $8,000, this would obviously be a better deal with a calculated Cap Rate of 8% (8,000/100,000).

Note: A typical Cap Rate for commercial investment properties ranges between 5 – 8% with an 8% cap rate typically viewed by seasoned investors as the more desirable type of investment.   However, for investors in Single family homes an cap rates above 8% are more typical.