Chartered Financial Analyst (CFA) Practice Exam Level 2

What formula represents the Cap Rate?

1. R0 = Gross Rental Income / Sales Price

2. R0 = NOI / Sales Price

3. R0 = Effective Gross Income / Vacancy Rate

4. R0 = Sales Price / NOI

The correct answer is: R0 = NOI / Sales Price

The capitalization rate, commonly known as the cap rate, is a key concept in real estate finance that helps investors assess the potential return on an investment property. The formula for the cap rate is calculated as the Net Operating Income (NOI) divided by the sales price of the property. Net Operating Income represents the income generated from the property after deducting operating expenses, which include property management fees, maintenance costs, property taxes, and insurance. By dividing the NOI by the sales price, investors can determine the percentage return they can expect based on the income generated from the property relative to what they would pay to acquire it. This ratio provides valuable insights into the profitability of a real estate investment. A higher cap rate often indicates a more attractive investment opportunity, suggesting that the property generates more income in relation to its price. Therefore, the formula R0 = NOI / Sales Price accurately captures this relationship and serves as a fundamental tool for evaluating real estate opportunities. In contrast, other formulas listed do not represent the cap rate; for example, gross rental income divided by sales price reflects gross return but doesn't consider operating expenses, while the other formulas involve unrelated income metrics or ratios. Thus, the correct understanding of the cap rate relies specifically on the NOI and sales