where 
the net operating income is the expected annual income generated by the property like rentals and is arrived at by deducting all the expenses incurred for managing the property these expenses include the cost paid towards the regular upkeep of the facility as well as the property taxes the current market value of the asset is the present day value of the property as per the prevailing market rates in another version the figure is computed based on the original capital cost or the acquisition cost of a property capitalization rate net operating income purchase pricehowever the second version is not very popular for two reasons first it gives unrealistic results for old properties that were purchased several years decades ago at low prices and second it cannot be applied to the inherited property as their purchase price is zero making the division impossible additionally since property prices fluctuate widely the first version using the current market price is a more accurate representation as compared to the second one which uses the fixed value original purchase price those interested in learning more about capitalization rates may want to consider enrolling in one of the best online real estate schools interpreting the capitalization ratesince cap rates are based on the projected estimates of the future income they are subject to high variance it then becomes important to understand what constitutes a good cap rate for an investment property the rate also indicates the duration of time it will take to recover the invested amount in a property for instance a property having a cap rate of 10 will take around 10 years for recovering the investment different cap rates among different properties or different cap rates across different time horizons on the same property represent different levels of risk a look at the formula indicates that the cap rate value will be higher for properties that generate higher net operating income and have a lower valuation and vice versa there are no clear ranges for a good or bad cap rate and they largely depend on the context of the property and the market say there are two properties that are similar in all attributes except for being geographically apart one is in a posh city center area while the other is on the outskirts of the city all things being equal the first property will generate a higher rental compared to the second one but those will be partially offset by the higher cost of maintenance and higher taxes the city center property will have a relatively lower cap rate compared to the second one owing to its significantly high market value it indicates that a lower value cap rate corresponds to better valuation and a better prospect of returns with a lower level of risk on the other hand a higher value of cap rate implies relatively lower prospects of return on property investment and hence a higher level of risk while the above hypothetical example makes it an easy choice for an investor to go with the property in the city center real world scenarios may not be that straightforward the investor assessing a property on the basis of the cap rate faces the challenging task to determine the suitable cap rate for a given level of risk gordon model representation for cap rateanother representation of the cap rate comes from the gordon growth model which is also called the dividend discount model ddm it is a method for calculating the intrinsic value of a company s stock price independent of the current market conditions and the stock value is calculated as the present value of a stock s future dividends mathematically stock value expected annual dividend cash flow investor s required rate of return expected dividend growth rate rearranging the equation and generalizing the formula beyond dividend required rate of return expected growth rate expected cash flow asset valuethe above representation matches the basic formula of the capitalization rate mentioned in the earlier section the expected cash flow value represents the net operating income and the asset value matches the current market price of the property this leads to the capitalization rate being equivalent to the difference between the required rate of return and the expected growth rate that is the cap rate is simply the required rate of return minus the growth rate this can be used to assess the valuation of a property for a given rate of return expected by the investor for instance say the net operating income of a property is 50 000 and it is expected to rise by 2 annually if the investor s expected rate of return is 10 per annum then the net cap rate will come to 10 2 8 using it in the above formula the asset valuation comes to 50 000 8 625 000 limitations of the cap ratealthough capitalization rate can be a useful metric for properties that provide stable income it is less reliable if a property has irregular or inconsistent cash flows in these circumstances a discounted cash flow model might be a better way to measure the returns from an investment property the capitalization rate is only useful to the extent that a property s income will remain stable over the long term it does not take into account future risks such as depreciation or structural changes in the rental market that could cause income fluctuations investors should take these risks into account when relying on cap rate calculations 