Capitalization Rate (Cap Rate)
Definition and meaning of Capitalization Rate (Cap Rate) in real estate.
Capitalization rate, which is commonly referred to as the cap rate, is a metric used to estimate the potential rate of return on a real estate investment property. It is calculated by dividing the property's annual net operating income by its current purchase price or market value.
In more detail
Cap rates allow investors to compare the relative profitability of different commercial or multi-family properties without considering mortgage financing costs. A higher cap rate generally indicates a higher potential return, but it also reflects a greater level of risk associated with the investment. Conversely, a lower cap rate indicates a safer, more stable asset that generates a lower return. Cap rates vary significantly by property type, asset class, and geographic location.
Key facts
| Category | Real Estate Investing |
|---|---|
| Also known as | Cap rate |
| Formula | Net Operating Income divided by Current Market Value or Purchase Price |
| What it excludes | Mortgage payments, tax liabilities, and financing costs |
An investor purchases a retail building for one million dollars that generates eighty thousand dollars in annual net operating income, resulting in an eight percent capitalization rate.
Frequently asked questions
What is a good capitalization rate for an investment property?
A good cap rate depends on the investor's risk tolerance and location, but rates typically range between four percent and ten percent in the United States.
Why does a lower capitalization rate indicate lower risk?
Properties in highly desirable areas with stable tenants usually command higher prices and lower cap rates because investors are willing to accept lower returns for safer assets.