The idea of Cap Rate (Capitalization Rate) is often misunderstood and my objective in this post is to provide clarity and cut through any confusion. The specific definition if Cap Rate is provided by CCIM and other organizations to provide a consistent way to evaluate the performance of Investment Property

The Cap Rate is the Net Operating Income for the first year of ownership divided by the Purchase Price of the Building.

Cap Rate = NOI / Purchase Price

The Net Operating Income includes the following items:

• Property Taxes
• Property Hazard, Fire, Wind, and Flood Insurance
• Property Management Fees
• Reserves for replacement of roofs, HVAC, etc.
• Lawn Maintenance
• Building Maintenance
• Recurring expenses associated with the operation of the building.

The Net Operating Expenses do Not include:

• Interest on the Mortgage
• Mortgage Payments
• Depreciation on the property
• Non-recurring costs
• Replacement of large capital items (The roof, HVAC and similar expenses are captured in the reserve Numbers).

Generating much of this confusion is the difference between how expenses are calculated for Tax Purposes and how the are calculated for Evaluation Purposes.

For Tax Purposes we generally want to maximize the value to minimize our taxable income. We include (as allowed by accounting rules) the interest expense for the mortgage and the depreciation of the buildings. For evaluation purposes we only care about the actual financial performance of the property.