The capitalization rate, or “cap rate,” refers of the property's net operating income, which takes into account expenses, but which does not include financing expenses to property asset value. At the time of acquisition, the cap rate can be figured by dividing a property's net operating income by the property's purchase price.
Example: A property that has a gross income of $500,000 and operating expenses of $200,000 (for a net operating income of $300,000), and a purchase price of $1,000,000 would be calculated as:
Net Operating Income ÷ Purchase Price = $300,000 ÷ $1,000,000 = 30.0% cap rate.
Since cap rates convert an income stream to value, the above calculation can be re-figured so that a given income stream and an assumed cap rate can be used to estimate the value of a comparable property, or even to estimate the future value of a property. Investors often use cap rates to convert future projected income streams into that property's future value.