The capitalization rate, or cap rate, is the ratio between the annual net operating income given by an asset (this is usually used for real estate, so real estate is usually the asset) and the asset’s capital cost (capital cost is the original price paid for the asset) or the asset’s market value.

The equation is as follows:

Capitalization Rate (”Cap Rate”) = Annual Net Operating Income/Capital Cost (or Market Value)

This equation is important for an investor to pay attention to as it shows how well their investment is doing and if it is profitable against the opportunity cost of putting that money in a different investment. A similar concept to the ROI (Return on Investment) formula