# What is a Capitalization Rate?

The capitalization rates (Cap Rate) is the expected rate of return for commercial real estate investment. It is calculated by taking the Rental Income, divided by the Current Market Value. Another computation is using Net Operating Income divided by Net Capitalization Rates.

It is the intrinsic rate of return since and does not consider leverage. Or the investment is assumed to be purchased in cash. Other factors being disregarded in the computation for cap rate is the time value of money and additional income for future property improvements.

#### Capitalization Rates Computation Formula and Example

The cap rate is computed as follows:

Gross Cap Rate = Rental Income/Market Value

or

Net Capital Rate = Net Operating Income/Market Value

Let’s say that an investor is considering investing in a property with a market value amounting to \$1.5 million with an expected annual rent income of \$100K and maintenance costs and property tax amounting to 40K.

Gross Cap Rate = 130K/1.5 million

= 8.67%

Net Cap Rate      = (130K-40K)/1.5 million

= 6%

Another way to consider the cap rate is as a risk-free rate of return + risk premium.

For example, treasury bonds are considered a risk-free investment. Let’s say that the risk-free return is 3.5%, while the expected rate of return is 8%. It means that 4.5% is the risk premium or compensation for the risk you are taking for investing in commercial real estate.

#### What is Considered as a Good Cap Rate?

A reasonable cap rate would depend on a transaction and whose point of view you are taking. If you are buying a property, you want a higher capitalization rates so that you get more income for the money you have to pay.