The capitalization rate, or cap rate, is a ratio that is used to estimate the value of properties that produce income. The cap rate is net income divided by the value or sale price of a property, expressed as a percentage. Lenders, investors and appraisers use the cap rate when estimating the purchase price for types of income producing properties.

An overall market cap rate is estimated by evaluating the financial information of similar properties that were recently sold in a specific market. The market cap rate provides a trustworthier estimate of value than a market gross rent multiplier, as the cap rate formula uses more of a property's financial information. The gross rent multiplier can only use a property's gross rent and selling price.

The cap rate formula uses a property's gross rent, property-selling price, vacancy amount, non-rental income and operating expenses. This provides a more reliable estimate of the value. The seller of a piece of income property will always want to get the best rate for the property or sell at the lowest cap rate possible. The buyer of the property will want to purchase at the lowest possible price possible, which translates into a higher cap rate.

The higher the cap rate, the lower the selling price. From a buyer's or investor’s point of view, the highest cap rate is the best possible price. Investors expect a large return when investing in high-risk properties.

The cap rate varies in areas for a variety of reasons, including levels of crime, desirability of location and the condition of the area. A lower rate can be expected in desirable areas of a city, while the highest rate is predicated for areas that are not so desirable. This is to compensate for the added risk of properties in that particular area.

If capitalization rates are increasing and net operating incomes are decreasing over time in a specific market area, then property values will decline. By checking with a lender or appraiser, you can ascertain the rate for a particular property in a specific area. If financial information is unavailable, a rate may be determined by analysis of its component parts, but this may reduce the credibility of the outcome. A cap rate produced by analyzing recent buyer and seller action in a specific market will give you the best market estimate for a specific property.