What is a Capitalization Rate “Cap Rate”
A rate of return on a real estate investment property based on the expected income that the property will generate. Capitalization rate is used to estimate the investor’s potential return on his or her investment. This is done by dividing the income the property will generate (after fixed costs and variable costs) by the total value of the property. If you want to get technical, it is basically the discount rate of a perpetuity. Capitalization Rate = Yearly Income/Total Value. Capitalization rate is a good jumping-off point to quickly compare many investment opportunities, but it should not be the sole factor in any real estate investment decision. There are a multitude of other factors that need to be looked at such as the growth or decline of the potential income, the increase in value of the property, and any alternative investments available.
For example, if Amanda buys a property that will generate $125,000 per year and she pays $900,000 for it, the cap rate is: 125,000/900,000 = 13.89%.
But it gets a little more complicated. What if the property’s value rises to $2 million two years later? Now the cap rate is a less favorable 125,000/2 million = 6.25%. This is because Amanda could potentially sell the property for $2 million and use that money for another investment.