The capitalization rate, often just called the cap rate, is a metric that is widely used in the real estate investment industry to estimate the potential return on an investment property.
The cap rate is calculated by taking the net operating income (NOI) of the property (i.e., the income the property generates minus all operating expenses, but not including any financing costs or taxes) and dividing it by the property’s market value.
Cap Rate = Net Operating Income / Current Market Value
This ratio is usually expressed as a percentage, and it serves as a way to compare the profitability and risk of different real estate investments. A higher cap rate generally suggests a higher risk but also a potentially higher return, whereas a lower cap rate might suggest a lower risk but also a potentially lower return. However, it’s important to keep in mind that like any financial metric, the cap rate has its limitations and should be used in conjunction with other investment analysis tools when evaluating a real estate investment.