What is a Capitalization Rate? Whilst the capitalization (or its commonly used abbreviation CAP) rate is important in commercial real estate, cap rates are commonly misunderstood and sometimes incorrectly calculated. Assuming an all cash purchase, the cap rate represents the percentage return an investor would receive. Essentially the cap rate is the ratio of net operating income to property asset value. An Example: If a property was listed for $1,000,000 and generated an net operating income of $100,000, then the cap rate would be calculated as: $100,000/$1,000,000 = 10% Why Use a Cap Rate? Cap rates are useful for the commercial property investor as a tool to quickly sum up a potential purchase and allow an overview comparison as to which property may pose as a riskier purchase. Cap rates may also be used as a historical trend to highlight where the market may be heading. If cap rates are compressing then values may be heading upwards. Why NOT Use a Cap Rate? Cap rates should not always be used as a blanket property evaluation tool. Where a property has a varied and/or inconsistent income stream a discounted cash flow analysis should be undertaken.