The capitalization rate (also known as the cap rate) is used in the commercial real estate field to represent the expected rate of return on real estate investment properties. This measure is based on the expected net income from the property and is calculated by dividing the net operating income by the value of the property asset and expressed as a percentage. It is used to estimate investors' potential investment returns in the real estate market.
Although the cap rate can be used to quickly compare the relative value of similar real estate investments in the market, it should not be used as the only indicator of investment strength because the cap rate does not take into account leverage, time value of money and, among other factors, property improvements future cash flow. There is no clear range for the quality of the cap rate, they are largely dependent on the real estate and market conditions.
The cap rate is the most popular measure by which you can assess the profitability and return potential of real estate investments. The cap rate simply represents the return on assets within a one-year time frame, assuming that the asset was purchased with cash rather than loans. The capitalization rate represents the intrinsic, natural and unleveraged rate of return of real estate.
Capitalization rate formula
There are several versions for calculating the capitalization rate. In the most popular formula, the capitalization rate of real estate investment is calculated by dividing the real estate net operating income (NOI) by the current market value. Mathematically
Capitalization rate = net operating income / current market value