What Is Cap Rate in Real Estate?

Cap rate, short for capitalization rate, is a key metric investors use to evaluate the return on a real estate investment. It measures a property's annual net operating income (NOI) compared to its market value or purchase price. Cap rate helps investors compare the profitability and risk of different investment properties.

How Cap Rate Works

Cap rate reflects the relationship between a property's income and value. It does not include financing costs, making it a reliable way to compare properties regardless of how they’re financed. A higher cap rate generally indicates higher potential returns but also higher risk.

  • Formula: Cap Rate = Net Operating Income ÷ Property Value
  • Uses NOI, not gross income
  • Helps investors estimate investment performance
  • Varies by property type, condition, and market

Example of Cap Rate

If a rental property generates $36,000 NOI per year and is valued at $600,000:

Cap Rate = $36,000 ÷ $600,000 = 6%

An investor can now compare this 6% return to similar properties in the market to evaluate whether the property is appropriately priced and offers competitive returns.

Cap Rate vs. Other Investment Metrics

  • Cap Rate: Measures return based on NOI and property value
  • Cash-on-Cash Return: Measures return on the actual cash invested
  • Market Value: Estimates what the property is currently worth
  • NOI: Used directly to calculate cap rate

Cap rate is most useful for comparing similar properties in the same market.

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