Cap-Rate Valuation

Builds onPresent Value of a Perpetuity — if this page feels steep, start there.

V = \frac{NOI}{\text{cap rate}}

$NOI$: net operating income: rents minus operating costs — before any mortgage payments or taxes on income
$r_{cap}$: the capitalization rate: the market's required unlevered yield for this type and location
$V$: the property's value — the price consistent with the quoted cap rate
$NOI / V$: the same identity backwards: extract the cap rate from an observed sale

Why it must be true

Real estate people invented their own vocabulary for a formula you already know: this is the perpetuity identity wearing work boots. A building throwing off stable net operating income forever is worth that income divided by the rate the market demands — exactly $PV = PMT/r$ .

The "capitalization rate" is the market's required unlevered yield on the property type and location: 5% for a trophy apartment block in a gateway city, 9% for a tired strip mall in a shrinking town. Quoting cap rates is how the industry gossips about prices — "it traded at a 6 cap" tells a professional everything: price = NOI / 0.06.

The derivation

Treat the property as a flat perpetual income stream (the simplification the industry accepts for quoting):

V = \frac{NOI}{r_{cap}}

Read in both directions. Pricing: divide income by the market cap rate. Appraising the market: divide a sold building's NOI by its price to extract the cap rate other deals will be quoted against:

r_{cap} = \frac{NOI}{V}

If income is expected to GROW, the Gordon version applies and the quoted cap rate is really $r - g$ — which is why hot-growth markets trade at cap rates below any sane required return.

When to reach for it

Valuing income property from its stabilized NOI and a market cap rate — or backing the cap rate out of a comparable sale.

Listen for

“capitalization (cap) rate”“net operating income of …”“direct capitalization approach”“the property traded at a … cap”

Back-of-the-envelope

Estimate it in your head first — then the calculator only confirms.

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Years-purchase reciprocal: a 5 cap = 20 years' income; an 8 cap = 12.5. Divide 100 by the cap rate for the price-to-income multiple.
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Small cap-rate moves are huge price moves: NOI fixed, a 5→6 cap repricing knocks ~17% off the value. Rate-hike questions hide there.
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NOI must be OPERATING income — if the question sneaks in mortgage interest or capex reserves, strip financing out before dividing.

Traps in applying it

✗Using cash flow after debt service instead of NOI — cap rates are unlevered; the mortgage belongs to the buyer, not the building.
✗Multiplying instead of dividing (value is income OVER the rate).
✗Applying a stabilized cap rate to a temporarily vacant or under-rented year's NOI.

Limits & criticisms

Direct capitalization freezes one year's NOI into eternity — no growth, no capex cycles, no lease rollovers — so it misprices anything without stable income (development, value-add, heavy-vacancy assets), which get DCF treatment instead. The cap rate itself comes from comparable sales, so in thin or turning markets it is stale gossip: everyone quotes the last cycle's price until the next forced sale resets it.

Where it came from

Income capitalization descends from centuries of land valuation — English agricultural land was priced in "years' purchase" (the reciprocal of a cap rate) by the 1600s. The modern appraisal profession standardized the direct capitalization method in the 20th century, and today cap rates are commercial real estate's universal price language: REIT earnings calls, appraisal reports and the CFA curriculum all quote them, and the spread of cap rates over Treasury yields is a standard gauge of property-market froth.

One identity, 2 questions

The exam can hide any variable. Each face below is the same equation solved for a different unknown — drill them separately.

Price from income

V = \frac{NOI}{r_{cap}}

The appraisal face: the perpetuity identity in work boots — stable income over the market's required yield.

Drill this face →

Cap rate from a sale

r_{cap} = \frac{NOI}{V}

The market-reading face: every closed deal reveals the yield buyers accepted — the comp that prices the next building.

Drill this face →

On the BA II Plus

Worked example: A property's stabilized NOI is $1,000,000.00; the market cap rate for its type and location is 4.5%. Estimate its value.

1.1000000 [÷] 0.045 [=]income over the cap rate

→ $22,222,222.22

Drill this formula Back to the library