Understanding Cap Rate: The Essential Metric for Real Estate Investors
Learn how to calculate and interpret capitalization rate to evaluate investment properties effectively.
Capitalization rate, or cap rate, is one of the most important metrics in real estate investing. It represents the expected rate of return on a real estate investment property based on the income that the property is expected to generate.
To calculate cap rate, divide the property's Net Operating Income (NOI) by its current market value or purchase price:
Cap Rate = (Net Operating Income / Property Value) × 100
For example, if a property generates $50,000 in NOI and is worth $500,000, the cap rate is 10%.
Generally: - Higher cap rates (8-12%+) indicate higher returns but potentially higher risk - Lower cap rates (4-6%) suggest more stable, lower-risk investments - Average cap rates vary by market and property type
Cap rate helps you compare different investment opportunities and assess whether a property's price is justified by its income potential. However, it shouldn't be used in isolation - consider appreciation potential, market trends, and your investment goals.