Introduction

Understanding Cap Rates

Understanding Cap Rates

What Is the Capitalization Rate?

The capitalization rate (also known as cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property.

This measure is reliant on the net income which the property is expected to generate and is calculated by dividing net operating income by the property value. The resulting number is expressed as a percentage and is used to estimate the investor's potential return on their investment in the real estate market.

While the cap rate can be useful for quickly comparing the relative value of similar real estate investments in the market, it should not be used as the sole indicator of an investment’s strength because it does not take into account leverage, the time value of money and future cash flows from property improvements, among other factors.

There are no clear ranges for a good or bad cap rate, and they largely depend on the context of the property and the current market in the region.

Figure-Cap-Rate-Step-6

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