I've taught this so many times - I decided to write a quick tutorial on capitalization rates here so anyone can access this information easily.
Income (i.e. Rents)
Less Operating Expenses - real estate taxes, insurance, maintenance (all expenses except personal income taxes)
Equals: Net Operating Income
This is the cash flow you would get if you bought a property for cash before paying your personal income taxes. Ideally you'd be smart enough to buy the property in a IRA or Roth IRA and not have any personal income taxes.
Net Operating Income divided by Total Investment equals your Cap Rate. Total investment includes the acquisition of a property plus renovations. A high cap rate is better than a low cap rate assuming all other things are equal.
But there are many other things we can use cap rates for.
You can use cap rates to "see" where a market is. A market that has 25% cap rates and very low interest rates (cost of money) is a market that is emotionally in FEAR. That market just got through with a major devaluing of real estate and investors have a sick/visceral feeling in their guts that prevent them from taking advantage of amazing opportunities.
A market that has 6% cap rates and the cost of borrowing is running at 10% is a market that has been going up and investors are cocky- they think the market will go up indefinitely despite the fact that it doesn't make economic sense. This is a market you should be selling it despite the GREED factor of thinking "this thing is going up every day - I'd hate to get out too early."
You might want to make a BIG NOTE that most investment decisions are made in the GUT not in the head but by using cap rates you can possibly make better decisions with your head.
You can also use cap rates to make a better decision. If an investment/improvement in your property costs $1,000 and saves $500/year, is it a good deal? Well, using a 10% cap rate that improvement will raise the value of your property $5,000!!!! Sounds like an amazing deal to me. But without using that analysis it might not look like such a good deal. $500/.1 = $5,000.
As a practical matter there is no sense in calculating an exact cap rate. When I am standing in front of a building that I am evaluating I run the numbers quickly in my head.
$1,000 Rent (brain says $12,000 in income IF everything goes right)
Tenants pays utilities (brain says expenses will be between 30% of gross and 50% of gross depending on the answer to this question, the local real estate taxes and the condition of the property). Say $4,000 for the sake of this conversation.
(brains says $8,000 Net Operating Income)
Real estate broker says: $50,000. (Brain says maybe buy for $45 plus $5 in improvements)
Calculate: $8,000/$50,000 - 16% Cap Rate
If my cost of money (borrowing) is 10% this might be a deal.
If my cost of money is 18% I know I would lose money every month.