The capitalization rate, or cap, of an investment may be calculated by dividing the investment’s net operating income (NOI) by the current market value of the property (where NOI is the annual income on the property minus all operating expenses, which excludes the debt service).
Essentially it calculates your rate of return (%) if you paid all cash for the asset. It's most commonly used by lenders, brokers, and owner/operators to calculate the valuation of an asset. Below I outline an example where we look at an asset's value today, compared to a future projection. This is a key element in building a business plan for a property and why multifamily is so exciting. We can work to raise the NOI, which directly forces appreciation because of it's relationship to value.
Note that caps vary by location and also by asset type and class (e.g. class A assets will have lower caps than B and C). The capitalization rate is a popular and easy ratio to use, but it is not the sole factor in a real estate investment decision.
Another interesting way cap rates can be helpful is when they form a trend. If we're looking at cap rate trends over the past few years in a particular sub-market, then the trend can give us an indication of where that market is headed. For instance, if cap rates are compressing and trending downwards (which most markets are today), that means values are being bid up and a market is heating up. We might see confirmation of this in research reports that identify the MSA is in an emerging phase of the market cycle, called "recovery" which is followed by "expansion".
The formula for calculating the capitalization rate can be expressed in the following ways:
Capitalization Rate = NOI / Current Market Value
Current Market Value = NOI / Capitalization Rate
A current valuation example at an 8 cap:
$2,000,000 = $160,000 / .08
A projected valuation example at the same 8 cap:
Note that the NOI below reflects a small $50 rent raise to a 60 unit multifamily deal
$2,450,000 = $196,000 / .08