Financial Glossary
Cap Rate (Capitalization Rate)
Cap rate (Capitalization Rate) is a real estate valuation metric expressed as the ratio of a property's net operating income (NOI) to its current market value or acquisition price. Formula: Cap Rate equals NOI divided by Property Value, multiplied by 100. NOI is gross revenue minus all operating expenses excluding debt service and income taxes. Cap rate represents the unleveraged annual yield an investor would earn if the property were purchased with all cash. Lower cap rates indicate higher values relative to income, typically associated with lower-risk or higher-demand markets; higher cap rates imply higher risk, lower demand, or distressed conditions, but also potentially higher yields for buyers who accept that risk.
Problem & Application
An RV park generates $500,000 in gross revenue, $200,000 in operating expenses (management, utilities, insurance, maintenance, property tax), and therefore $300,000 in NOI. Listed at $3 million, the implied cap rate is 10%. A buyer using a $3 million purchase price to calculate cap rate at 10% must scrutinize the NOI carefully: if the seller excluded a $40,000 annual capital reserve for road and utility upkeep or failed to include market-rate management fees because the owner self-manages, normalized NOI falls to approximately $240,000 -- implying a true cap rate of 8% at the asking price. That 2-percentage-point difference is significant because it changes whether the deal meets the buyer's return threshold. Buyers must normalize NOI before comparing cap rates across properties or markets, and they must ensure the denominator (purchase price) reflects actual acquisition costs including closing and transition expenses.
In Short
Cap rate is the standard quick measure of real-estate yield, and reliable NOI is what makes it trustworthy.