Capitalization Rate

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DEFINITION of 'Capitalization Rate'

A rate of return on a real estate investment property based on the expected income that the property will generate. Capitalization rate is used to estimate the investor's potential return on his or her investment. This is done by dividing the income the property will generate (after fixed costs and variable costs) by the total value of the property. If you want to get technical, it is basically the discount rate of a perpetuity.

Capitalization Rate = Yearly Income/Total Value

Also known as "cap rate".

BREAKING DOWN 'Capitalization Rate'

Capitalization rate is a good jumping-off point to quickly compare many investment opportunities, but it should not be the sole factor in any real estate investment decision. Many more factors need to be looked at such as the growth or decline of the potential income, the increase in value of the property, and any alternative investments available.

For example, if Stephane buys a property that will generate $125,000 per year and he pays $900,000 for it, the cap rate is: 125,000/900,000 = 13.89%.

But it gets a little more complicated. What if the property's value rises to $2 million two years later? Now the cap rate is a less favorable 125,000/2 million = 6.25%. This is because Stephane could potentially sell the property for $2 million and use that money for an alternative investment.

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RELATED FAQS
  1. How is Net Operating Income (NOI) used in real estate?

    Net operating income (NOI) is used in the real estate market to determine the revenue that a property generates less operating ... Read Full Answer >>
  2. What is the historical capitalization rate for real estate in New York City?

    Historical capitalization rates, or cap rates, for real estate in New York City and the rest of the country experience cyclical ... Read Full Answer >>
  3. What can capitalization rate tell investors about real estate bubbles?

    During real estate bubbles capitalization rates contract dramatically due to values being unsustainably stretched and incomes ... Read Full Answer >>
  4. How do REIT managers use capitalization rate to configure their portfolios?

    Real estate investment trusts (REITs), which buy and sell properties, use capitalization rates in two main ways to configure ... Read Full Answer >>
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