What is a CAP Rate?

CAP rate stands for capitalization rate. It's a metric that describes the rate of return on a property investment based on how much rent you expect to get. Investors use the CAP rate when making a purchasing decision since it helps them determine which investment property will give the best return on their money.

The CAP rate is the ratio of the net operating income derived from a property to the property's asset value. In simple terms, it's net rent divided by the sale price. The resulting figure represents the percentage of return you would receive from an all-cash property investment. Investors use the CAP rate to quickly size up a potential investment relative to other investment properties. Since one of the major components is rental income, CAP rates are usually projected based on an estimate of likely rents.

To figure out a CAP rate, let's look at a property that's on the market for $400,000. Imagine that the property will rent for $25,000 per year, and there will be $5,000 of expenses such as repairs, marketing and insurance costs; the net operating income is $25,000 less $5,000 or $20,000. The CAP rate is $20,000 divided by $400,000, or 5 percent. In the commercial real estate industry, it is common to say that this property sold at a 5 percent CAP rate, which means that your $400,000 cash investment is projected to earn an annual return of 5 percent.

CAP rates are an easy way to size up the risk associated with a property investment relative to a "safe" investment such as government bonds. Suppose, for example, that you put your $400,000 cash into 10-year treasury notes – considered a very low-risk investment – yielding around 2.5 percent annually. Now, you're comparing returns of 5 percent for the commercial property versus 2.5 percent for the government bonds. The 2.5 percent extra yield reflects the additional risk you assume over and above the risk-free treasuries, such as lease expiration, property value fluctuations and whether tenants will actually pay on time.

CAP rates correspond to the level of risk in a transaction, so whether a CAP rate is good or bad depends on how risk averse you are. In the above example, you could double the CAP rate to 10 percent by purchasing a cut-price building outside of the central business district for just $200,000, assuming it still rents at $20,000 annually. Now, you're taking the risk that there's tenant demand for this location, and that the demand will stay strong over the long-term. As an investor, you don't want a CAP rate that's lower than safe bond yields. Beyond that, the challenge is to figure out the right CAP rate based on the riskiness of the deal.