A 'CAP' rate is short for Capitalization Rate. This is the relationship between the price of a piece of real estate and the net operating income it produces, as a percentage, independent of any financing. So, for example a property with a price of $1,000,000 which produces a net operating income of $75,000 per year would have a 7.5% CAP rate ($75,000/$1,000,000=7.5%). An easy way to think about this is to imagine putting your money in another type of investment, a bank savings account: the interest rate paid on the bank deposit is like the CAP rate produced by an income property. A CAP rate is a very common method of comparing the value of different pieces of investment real estate, part of the income approach of valuing a property as it is based on the net income a property produces.

In concept, the idea of a CAP rate is simple; as with many things, however, the devil is in the details. The most common errors in understanding and calculating a CAP rate involve what items to include or exclude when calculating income and expenses.

Income: First you must calculate gross income, ie the pre-expense income a property generates from all sources - including any additional rent such as expense passthroughs collected from the tenants, and any other sources of income such as laundry machines, vending contracts, etc. A vacancy factor must be applied to the rental income; this often expresses actual vacancy, but will more properly calculate market vacancy taking into account the type, quality and location of the subject property and the overall market vacancy where it is located. These calculations give a gross income; then expenses must be subtracted from that to arrive at a net income figure.

Expenses: The key here is that in calculating operating income, operating expenses must be subtracted from the gross income. Generally, this means those expenses that will be expected to recur on a monthly or yearly basis and are required to operate the property. Examples of operating expenses include property taxes, hazard insurance, maintenance, utilities, management and repairs. Capital expenses are not included, examples of these are adding on to a structure, replacing a parking lot, paying leasing commissions, etc. Management is generally considered to be an operating expense, but is not always included where it is assumed a building will be managed by its owner or where management responsibilities will be minimal. The type of building or lease structure can also affect what is included under expenses. For example, in a true triple-net lease with no landlord responsibilities usually no expenses are subtracted as the tenant is responsible for paying all expenses directly. Sometimes reserves are included in a net operating income analysis, most typically by lenders; however in practice this is the exception rather than the rule.

Loan payments are never included in a CAP rate / net operating income analysis, as they are a function of an individual owner's situation (ie how much financing at what terms is placed on a property) rather than the income-producing performance of the property itself. Remember, a CAP rate is useful as a tool to compare one property with another, independent of financing.

There is certainly room for judgment calls to be made in what to include or exclude in such an analysis; the key is to be aware of what is included or not, so that intelligent comparisons can be made between different properties.

A CAP rate (and net operating income) can be the foundation for further financial analyses of investment real estate, such as a cash-on-cash return analysis (including the effect of hypothetical financing situations) or an internal rate of return (accounting for an anticipated sale of the property at some future time, and the hoped-for return of investment generated by that sale as well as the cash flow (return on investment) produced during the period of ownership).