The Capitalization Rate, aka Cap Rate is used in commercial real estate to calculate the expected rate of return on an investment property and is expressed as a percentage.

To calculate the Cap Rate for a specific property you need to know two things, (1) the purchase price of the property or the estimated value of the property (the “Property Value”) and, (2) the annual net operating income (“NOI”) generated from the cash flow of the property. A property’s NOI is calculated by taking the annual gross rental income minus the vacancy factor and operating expenses (in a future post we will review in depth NOI).

Now that we have these two variables, we can plug them into the formula:

**NOI ****÷ Property Value = Capitalization Rate**

For example, a retail building is listed for sale at $2,000,000 and it generates an annual NOI of $100,000, the Cap Rate would be calculated as follows:

**$100,000 ****÷ $2,000,000 = 5.0%**

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Now let’s assume your desired rate of return for a retail property is not 5.0%, but you require an 8.0% rate of return. By modifying the base formula, you can determine what a property is worth to you based on your expected rate of return by slightly modifying the base formula to the following:

**Property Value = NOI ****÷ Cap Rate**

Using the original example, we take the $100,000 NOI and divide it by your 8.0% expected rate of return to determine the price at which you would be willing to purchase the property.

**$1,250,000 = $100,000 ****÷ 8.0%**

In this scenario, if the property was listed for $2,000,000, but based on the math you would only want to offer $1,250,000 in order to generate your expected 8.0% rate of return based on the in-place income.

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Finally let’s assume the property is listed for $2,000,000, but the is no reported NOI in the listing. We know that you are expecting to make an 8.0% rate of return on your investment, so if we modify the base formula as follows, we can determine the required NOI for the property to justify the purchase price.

**NOI = Property Value ****× Cap Rate**

In our example, the property is listed for $2,000,000 and we have a required 8.0% rate of return, so we need to calculate the required NOI to support the purchase price. Based on these two variables, the property would need to generate the following NOI for you to consider the investment:

**$160,000 = $2,000,000 ****× 8.0%**

In this case, during your initial due diligence you would want to confirm the property did indeed generate $160,000 in NOI to support the $2,000,000 valuation using an 8.0% rate of return.

To learn more about Small Balance Commercial concepts and strategies, see our "Small Balance Commercial" blog category.

**Related: ***An Overview of the Visio Box, 5 Key Small Balance Commercial Loan Types*