How is the capitalization rate (cap rate) calculated, and what does it measure?

The cap rate equals net operating income (NOI) divided by the property's current market value or purchase price. NOI is calculated as gross rental income minus operating expenses (property taxes, insurance, maintenance, property management, vacancy allowance) but before debt service. A cap rate measures what the property would return in Year 1 as if purchased entirely with cash. Higher cap rates generally indicate higher risk or lower-quality markets, while lower cap rates are found in high-demand, lower-risk markets. A property generating $30,000 NOI purchased for $500,000 has a 6% cap rate.