Platform · Glossary
Capitalization rate (cap rate).
A property's annual net operating income divided by its price. The cap rate tells you what unlevered annual yield the property produces if you bought it for cash at the stated price and ran it at the stated income.
Formula
Cap rate = Net Operating Income (NOI) ÷ Property ValueExample: $24,000 NOI on a $400,000 property → 6.0% cap rate.
The industry capitalization valuation method
The cap rate is the central input in the capitalization valuation method, one of three industry-standard approaches to valuing income property. Each method answers a different question:
| Method | Starting point | Main question |
|---|---|---|
| Comparative valuation | Similar sales | What has the market paid? |
| Capitalization valuation | Income stream | What value does the income support? |
| Goal-convergent valuation | Investor goal | What price makes this work for me? |
The capitalization method works as a direct inversion of the cap-rate formula:
Property Value = NOI ÷ market cap rateIf a market trades at a 6.0% cap rate and a property nets $30,000, the capitalization method says the property is worth $500,000. This is how appraisers, lenders, and institutional buyers value rental property at scale.
How 3Y uses cap rate
Cap rate plays two roles in a 3Y report:
It generates the Market Estimate. 3Y reads the local market cap rate for the property's area — the in-product description is "Local market cap rate used to estimate what buyers may pay for similar income" — and applies the capitalization method to the property's modeled NOI. The result is the Market Estimate: what buyers in this market would typically pay for a property with this income.
It drives the cashflow score via the operating–market delta. The property's operating cap rate (NOI ÷ price under the 3Y Estimate) is compared against the market cap rate for the same area. The difference — operating_cap_rate − market_cap_rate — is one of the five inputs to the cashflow score in analysis.py. The scoring band runs from −3% (cap delta well below market, score 0) to +3% (cap delta well above market, score 100):
- Operating well above market → the property generates yield in excess of what the market currently pays for. That excess is structural cash flow strength — it survives small changes in vacancy, expenses, and rate.
- Operating at or below market → the deal depends on appreciation, rent growth, or leverage to produce returns. All three are legitimate strategies but they carry execution risk that pure cash flow doesn't.
When cap rate misleads
Cap rate ignores financing, capital expenditures, vacancy realism, and growth. A 9% cap rate property with deferred maintenance, a soft rental market, and a 2007 roof can underperform a 5% cap rate property in a stable, growing submarket. Cap rate is a screening lens, not a decision lens. The cashflow score and the 3Y Score close the gap by combining cap rate with DSCR, cash-on-cash return, cash velocity, and location strength.