Capitalization Rate (Cap Rate) is an investment valuation method which expresses, as a percentage, the ratio of the property's net operating income (NOI) to the value (price) of the property.  Mathematically, Cap Rate can be expressed as:  R=I/V where: R = cap rate; I = first-year net operating income; V = property value.

For example, a property with a net income of $150,000 and a purchase price of $2,000,000 has a Cap Rate of:  $150,000/$2,000,000 = 7.5%

Alternately, the formula can also be expressed as V=I/R when value is being determined, or I=RxV where income is being determined for a given price and cap rate.

This method of valuation is superior to Gross Rent Multiplier (GRM) because it uses net operating income (NOI), rather than potential rental income (PRI).  Using a property's net income accounts for all of the property's operating expenses, as well as any vacancy and credit losses; consequently, it gives a more accurate indicator of value than GRM.

The disadvantage of using Cap Rate as the sole investment criteria is that it only considers a one year forecast of income; it also does not account for the effects of appreciation, depreciation, financial leverage, or mortgage obligations.  Because these factors also affect the investor's true return on investment, Cap Rate should not be used as a measure of return on investment.  Cap Rate is a good "first step" in analyzing investment properties.