Cap rate
From Wikipedia, the free encyclopedia
A contraction of capitalization rate, a cap rate expresses the income a real estate investment generates as a percentage of the property's price or value.
A $1,000,000 property that generates $80,000 of investment income, for example, delivers an 8% capitalization rate, or cap rate, because $80,000 divided by $1,000,000 equals 8%.
Capitalization rates, or cap rates, provide a convenient tool for investors to use for roughly valuing a property based on its income. For example, if a real estate investment provides $160,000 a year in income and similar properties have sold based on 8% cap rates, the subject property can be roughly valued at $2,000,000 because $160,000 divided by 8% equals $2,000,000.
A capitalization rate, or cap rate, does not equal the rate of return on an investment in real estate. Nor should investors consider only capitalization rates when evaluating real estate income property.
The cap rate only recognizes the income a real estate investment produces and not the change in value of the property.
To get the rate of return on an investment, also known as an internal rate of return, the real estate investor adds (or subtracts) the price change percentage from the cap rate. For example, a property delivering an 8% capitalization, or cap rate, that increases in value by 2% delivers a 10% overall rate of return, or internal rate of return. As another example, a property delivering an 8% capitalization rate, or cap rate, that decreases in value by 2% delivers a 6% overall rate of return, or internal rate of return.
