Capitalization rate (or "cap rate") is a real estate valuation measure used to compare different real estate investments. Although there are many variations, the cap rate is generally calculated as the ratio between the annual rental income produced by a real estate asset to its current market value. Most variations depend on the definition of the annual rental income and whether it is gross or net of annual costs, and whether the annual rental income is the actual amount received (initial yields), or the potential rental income that could be received if the asset was optimally rented (ERV yield).

The rate is calculated in a simple fashion as follows:

Some investors may calculate the cap rate differently.

In instances where the purchase or market value is unknown, investors can determine the capitalization rate using a different equation based upon historical risk premiums, as follows:

For example, if a building is purchased for $1,000,000 sale price and it produces $100,000 in positive net operating income (the amount left over after fixed costs and variable costs are subtracted from gross lease income) during one year, then:

The property building's capitalization rate is 10% percent, or in other words, one-tenth of the building's cost is paid by the net proceeds earned in the year.

If the owner bought the building twenty years ago for $200,000 that is now worth $400,000, his cap rate is:

The investor must take into account the opportunity cost of keeping their money tied up in this investment. By keeping this building, they are losing the opportunity of investing $400,000 (by selling the building at its market value and investing the proceeds).