In short, the cap rate is equivalent to the return on investment you would receive if you were to pay all cash for a property, and therefore, it is a way of making the complexities of property investment more transparent. By definition, the capitalization rate is a ratio used to estimate the value of income producing properties.
Cap Rate = Net Operating Income / Property Price
Purchase Price: $500,000
Income Per Month: $15,000
Expenses Per Year: $100,000
NOI = Annual Income – Annual Expenses or (12 x $15,000) – ($100,000) or $80,000
Cap Rate = NOI / Property Price or $80,000 / $500,000 or 16%
Cap rate is a standard used industry wide and it's used many different ways.
High Cap Rates
High cap rate usually typifies a higher risk investment and a low sales price. High cap rate investment are typically found in poor, low income regions.
Low Cap Rates
Low cap rates usually typifies a lower investment risk with higher sales price. Low cap rates are typically found in middle to upper income regions.
From the example above, If you know what the NOI is and you know what the given cap rate, you can estimate the sales price.
Sales price = NOI/cap rate
If cap rate is 16% and NOI is $80,000
Sales price = $500,000