Capitalization Rate

Published Jan 25, 2023

Definition of Capitalization Rate

The capitalization rate, also known as the cap rate, is a measure of the rate of return, typically on a real estate investment. It is calculated by dividing the net operating income of a property by its current market value (i.e., capitalization rate = net operating income / current market value). That means it is an estimation of the potential return an investor can earn on a real estate investment.

Example

To illustrate this, let’s look at an example. Imagine an investor is looking to buy a rental property for USD 500,000. The property is expected to generate a net operating income of USD 50,000 per year. In this case, the capitalization rate would be 10%, which is calculated by dividing the net operating income (USD 50,000) by the current market value (USD 500,000).

Why Capitalization Rate Matters

The capitalization rate is an important measure for investors when it comes to evaluating potential investments. It allows them to compare the expected rate of return on different investments and decide which one is the most attractive. In addition to that, it is also used by lenders to determine the loan-to-value ratio of a property. That means it is a critical factor when it comes to deciding whether or not to approve a loan.