The capitalization rate is the rate of return an investor can expect from an investment in real estate, assuming they pay all cash. The cap rate is used to assess the potential of various investment opportunities, giving investors a quick way to analyze a real estate investment. However, it does have limited usefulness as it doesn’t take into account leverage or a mortgage. As well, there are no set standards for a good or bad cap rate—as it’s best used when analyzing similar properties that are in the same market.  

There are several ways to calculate the cap rate. The most popular formula is calculated by dividing the property's net operating income (NOI) by the current market value. Mathematically, the cap rate calculation looks like this:

Net operating income is the expected annual rental income generated by the property. The net income is calculated by deducting all operating expenses incurred for managing the property from the rental income. These expenses include the costs of regular upkeep of the property, such as maintenance expenses, as well as property taxes and insurance.

The current market value of the asset is the present-day value of the property based on market rates, also known as the fair market value. Basically, it’s what you could sell the property for today. 

Cap rates can also be calculated based on the original or acquisition cost of the property—net operating income divided by the purchase price—although this version is not very popular. Firstly, it gives unrealistic results for old properties that were purchased several years or decades ago at low prices. Secondly, it cannot be applied to the inherited property as their purchase price is zero, making the division impossible. 

Additionally, since property prices can fluctuate widely, the first version that uses the current market price is a more accurate representation as compared to the second one.

The best use of the cap rate is to help analyze different investment opportunities. If one rental property investment offers an estimated four percent cap rate and another property has a cap rate of eight percent, an investor is likely to focus on the latter.
 
Cap rates can also allow commercial property owners to analyze trends. Trends can show where the market may head, allowing for adjustments based on estimated rents. There is a limit to their usefulness, however: Investment properties with irregular or complicated cash flows can't rely on simple capitalization rates. In the case of irregular cash flows, other return metrics or methods might be best used, such as a discounted cash flow (DCF) analysis.

One alternative to the cap rate is the dividend discount model (DDM), which calculates the intrinsic value of a company's stock market price. The stock’s value is the present value of future dividends (or cash flows). The DDM is similar to a DCF analysis. Here the stock’s value is the expected future dividends or cash flows dividend by the investor’s required rate of return less the expected dividend growth rate. 

Comparing the cap rate to the dividend discount model, the expected dividend and cash flow value represents the net operating income. The stock or asset value is akin to the current market price of a piece of property. Thus, the cap rate is similar to the difference between the required rate of return and expected growth rate. With this, investors can more easily compare other investment opportunities, such as stocks, with that of rental property ownership. 

Consider an apartment building with an annual NOI of $75,000 and an expected 2.5 percent increase in NOI expected yearly. The investor has a required rate of return of 10 percent, which means their cap rate would be 7.5 percent. Using the DDM, the property’s value would then be $100,000. 

In addition to cap rate and DCF analysis, there are other baseline formulas and metrics real estate investors, notably commercial real estate investors, should familiarize themselves with when analyzing investments. For instance, there’s cash-on-cash return, internal rate of return and return on investment that can be used when valuing a property. 

For those who are familiar with finance but new to real estate, a cap rate is the reverse of the price-to-earnings (P/E) ratio used in the stock market. While the P/E ratio measures the price, or market value, of a stock divided by its earnings per share, the cap rate measures the annual net operating income of a property, divided by its value. Like the P/E ratio, if there is no income—i.e. the property is not an income producer—then the cap rate cannot be found. 

Although cap rates will vary by property type and real estate market, a rule of thumb is that a solid baseline cap rate to shoot for is four percent—but it really depends on the market. The formula puts net operating income in contention with the property value. Investors want properties with solid income generation, but are also hoping for deals with a lower purchase price. This logic means investors are aiming for a higher cap rate, so a cap rate of four to 10 percent can historically be viewed as a “good” investment.

An investment property competes in the capital market with other investment vehicles. Falling interest rates mean less yield, or income, from fixed-income and risk-free investments, such as Treasuries issued by the Federal Government. Investors tend to lean on alternative investment vehicles like rental properties. Lower interest rates can also spur greater demand for real estate loans, increasing demand further.

With more capital flowing to real estate while the supply of property investments tends to stay rather constant, investors are forced to bid up prices. Assuming property NOIs remain rather steady, higher interest rates tend to force capitalization rates lower.