What is a cap rate - A cap rate is what investors expect to earn as a percentage of their investment on an annual basis.
Commercial real estate valuation is a very complex business with many variables that affect price. Over the years investors found that they needed a way to compare property values, essentially price, in a market using a shorthand method, thus capitalization rates or cap rates came into general use. In simple terms, a cap rate is what investors expect to earn as a percentage of their investment on an annual basis. For example, a property with a cap rate of 10 tells a buyer that he should expect a 10% return on his investment assuming a debt free transaction.
How to calculate a cap rate - Formally, Direct Capitalization (cap rate) is a method used to convert a property's annual net income (NOI), into an estimate of the property's value.
Value = Net Operating Income / Capitalization Rate
Cap Rate = Net Operating Income / Value
In general, the lower the cap rate, the higher the property's value, and the higher the cap rate, the lower the value. In other words, a property with a lower cap rate compared to a property with a higher cap rate will return less income to the investor.
Markets like San Francisco, Manhattan, Seattle and Miami tend to have some of the lowest cap rates in the country. Properties located in secondary and tertiary markets tend to have higher cap rates rewarding the investor for taking additional risk by purchasing in a smaller market.