Definition of Capitalization Rate
A capitalization rate is a mathematical formula used to provide an estimated rate of return on a property investment. The capitalization rate, often called a cap rate is primarily used by an investor as it provides a ratio between Net Operating Income (NOI) and a property’s assessed value.
Why is this term important?
Before buying an income property, an investor will calculate the potential risks and rewards of each potential by using the capitalization rate. By using the cap rate, the investor is able to look at the financial gain of the investment without being distracted by specific elements of each property. In this way, the capitalization rate is able to strip out the differences when comparing properties and provide a purely mathematical comparison of income properties.
Examples of term
If a property was listed for $1 million and generated a Net Operating Income (NOI) of $100,000, then the capitalization rate (cap rate) on the property would be 10% ($1 million / $100,000 = 10%).