The return on a real estate investment, calculated as the total unlevered, pre-tax cash flow of a real estate project divided by the total capital invested, typically annualized (expressed as an annual return). This return measure does not take into account the time value of money, but nevertheless investors use it as a screening tool for evaluation purposes based on an investor’s alternatives and the risk of investment.

The free and clear return (also known as capitalization rate or for short as cap rate) 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 (free and clear return) 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.

The free and clear return is the unlevered (debt-free) equivalent of the cash-on-cash return, and hence sometimes known as the unlevered cash-on-cash return.