What factor does the capitalization rate rely on?

The capitalization rate, commonly referred to as the "cap rate," is a critical metric used in commercial real estate to assess the profitability and value of an investment property. It specifically relies on net operating income (NOI) because this figure reflects the property's income after operating expenses are deducted but before financing costs are taken into account.

The formula to determine the cap rate is typically expressed as the net operating income divided by the property's current market value (or purchase price). This calculation gives investors a percentage that helps them evaluate the expected return on their investment in relation to the property's value.

Understanding net operating income is essential because it represents the actual earnings that the property generates, allowing investors to make informed decisions based on the property's economic performance. A higher cap rate suggests a greater potential return, assuming risk and market conditions remain constant. Thus, the capitalization rate is fundamentally tied to this measure of a property's financial health.