Capitalization Rate is the rate at which the Net Operating Income (remaining income after all expenses have been paid) repays the purchase price on an annual basis. For example :
If you purchased commercial real estate for $1,500,000 and your net operating income was $150,000 per year, your Cap Rate would be 10%.
Cap Rate = Net Operating Income ($150,000) / Selling Price ($1,500,000)
A Cap Rate is very important to consider since it is an indirect measurement of how fast an investment will pay for itself. In the example above, the purchased investment will be fully capitalized (pay for itself) after ten years. If the capitalization rate were 5%, the payback period would be twenty years. Cap rates normally range between 7-12% depending on the market.