The return on investment made in a real estate property. The rate of return is determined by dividing a property’s net operating income (NOI) by its current market value. This rate, expressed as a percentage, is an estimation for the potential return on a real estate investment. This rate is a key input in the calculation of the value of a real property (capitalization) whereby annual project income is divided by that rate. Capitalization is the worth (value) of a real estate property, applying the cap rate. Cap rate measures the performance of an investment in a property without taking into consideration any mortgage financing (funding costs).

Capitalization= annual income × cap rate

Cap rate, per se, is determined using the following formula:

Cap rate %= (NOI ÷ current MV) × 100

Current market value is the sales price of the property at the time of calculation.

The cap rate correlates “inversely” with risk: high-risk investments (in low-income areas) require low cap rates, while low-risk investments (in high-income areas) require high cap rates.