Cap rates are expressed in percentages and are returns for a single point. They can be used to assess an investment property or to compare properties.
Cap rates can often be compared with a coupon on a bond because they allow you to express payment in a percentage of an asset's value.
Cap rates can be used to determine which investment is more risky or safer. A lower cap rate generally means that it is safer or less risky to invest, while a higher rate can mean more risk.
A cap rate can be calculated by simply dividing the annual NOI by the market value. A property worth $10,000,000 and generating $500,000 in NOI would have an annual cap rate of 5%.
Real estate investing's "cap rate" is the unlevered return on an asset that is based on its annual net operational income (NOI).
This same cap rate formula can be used to estimate the building's value based on its NOI. If you know that the property generates $500,000 in NOI, and that the appropriate cap rate (i.e. unlevered return) is 5% for a comparable project in the market, then you can divide $500,000 by 5 to get a $10 million value. The same project could be worth only $8.3 million if the market cap rate is 6%. This illustrates how changing return expectations in the market (in this instance, the cap rate), can cause implied real property values to fluctuate as discussed further below.
When evaluating the performance or potential real estate investment, the cap rate (or capitalization rate) is the most frequently used return metrics.