What is cap rate and how to use it in real estate
A practical explanation of capitalization rate, the difference between cap rate and ROI, and a simple real estate calculation example.
Capitalization rate, usually called cap rate, compares a property net operating income with its value. It helps investors compare assets independently from how they are financed.
The basic cap rate formula
Cap rate = annual net operating income divided by property value. If a property produces EUR 8,000 after operating costs and is worth EUR 200,000, the cap rate is 4%.
Debt payments are usually excluded from net operating income. The goal is to evaluate the property itself, not a specific financing structure.
Cap rate is not ROI
ROI measures the return on the investor own capital. Cap rate measures the income yield of the asset. Two properties can have the same cap rate but very different ROI depending on debt, interest and down payment.
Cap rate is useful for comparing assets, while ROI shows how efficiently a particular investor capital is working.
How to interpret cap rate
Lower cap rates often appear in strong locations with higher liquidity and expected price growth. Higher cap rates may be attractive, but they can also signal higher tenant, technical or liquidity risk.
- compare similar property types in similar locations,
- do not calculate cap rate without repair and vacancy reserves,
- check whether extra yield only compensates for extra risk,
- combine cap rate with cash flow and LTV at portfolio level.
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