Cap rate is a real estate term that refers to the ratio of the net operating income (NOI) generated by a particular property to the property’s sales price. Cap rates are used by investors as one indication of how desirable a particular property may be as an investment. There are two parts to a cap rate: capitalization rate and value.

The cap rate is a useful metric for real estate investors looking to evaluate their existing or potential investments, because it gives an indication of how well that property will generate cash flow. It does not take into account other factors like cash-on-cash return and loan payments, but these can be calculated as well to give a complete picture of your investment.

For example, say an investment property has a current market value of $500,000 and is expected to generate $40,000 in net operating income after expenses. Using the above formula we compute:

Cap Rate = 40,000 / 500,000 = 0.08 or 8%

The cap rate formula is as follows:

(Net Operating Income / Purchase Price) x 100 = Cap Rate in percentage form

A cap rate of 10% indicates that the property generates $10,000 per year for every $100,000 in price. Put another way, it would take 10 years for a property to pay for itself if you use only income to finance the purchase.