Capitalization Rate

AAA

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".

INVESTOPEDIA EXPLAINS '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.

RELATED TERMS
  1. Interest Rate

    The amount charged, expressed as a percentage of principal, by ...
  2. Capitalization

    1. In accounting, it is where costs to acquire an asset are included ...
  3. Perpetuity

    A constant stream of identical cash flows with no end. The formula ...
  4. Overcapitalization

    When a company has issued more debt and equity than its assets ...
  5. Dividend Discount Model - DDM

    A procedure for valuing the price of a stock by using predicted ...
  6. Present Value - PV

    The current worth of a future sum of money or stream of cash ...
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 >>
  5. Where can I find year-to-date (YTD) returns for benchmarks?

    Benchmarks are securities or groups of securities against which investment performance is analyzed. Examples of popular equity ... Read Full Answer >>
  6. What is the effective interest method of amortization?

    The effective interest method is an accounting practice used for discounting a bond. This method is used for bonds sold at ... Read Full Answer >>
Related Articles
  1. Personal Finance

    How Interest Rates Affect Property Values

    When interest rates fall, real estate prices tend to increase. Why? Find out here.
  2. Home & Auto

    Can Real Estate Stabilize Your Portfolio?

    History suggests that real estate can provide diversification and a hedge against inflation.
  3. Home & Auto

    Simple Ways To Invest In Real Estate

    Owning property isn't always easy, but there are plenty of perks. Find out how to buy in.
  4. Fundamental Analysis

    Taking Stock Of Discounted Cash Flow

    Learn how and why investors are using cash flow-based analysis to make judgments about company performance.
  5. Professionals

    Why Investors Are Bailing on Bond ETFs

    Investors are fleeing bond ETFs. Should you follow the herd? Hint: It depends on the type of bond.
  6. Professionals

    Is a Bond Market Selloff Coming?

    A big investment management company is concerned about bond market conditions and allocating more capital to cash. Should you follow?
  7. Credit & Loans

    What is a Syndicated Loan?

    A syndicated loan is one that involves a group of lenders (called the syndicate) who pool their lending resources to make a loan.
  8. Economics

    Understanding Limited Liability

    Limited liability is a legal concept that protects equity owners from personal losses due to their ownership interest in the company.
  9. Fundamental Analysis

    Explaining the Empirical Rule

    The empirical rule provides a quick estimate of the spread of data in a normal statistical distribution.
  10. Economics

    Explaining Demographics

    Demographics is the study and categorization of people based on factors such as income level, education, gender, race, age, and employment.

You May Also Like

Hot Definitions
  1. Bund

    A bond issued by Germany's federal government, or the German word for "bond." Bunds are the German equivalent of U.S. Treasury ...
  2. European Central Bank - ECB

    The central bank responsible for the monetary system of the European Union (EU) and the euro currency. The bank was formed ...
  3. Quantitative Easing

    An unconventional monetary policy in which a central bank purchases private sector financial assets in order to lower interest ...
  4. Current Account Deficit

    A measurement of a country’s trade in which the value of goods and services it imports exceeds the value of goods and services ...
  5. International Monetary Fund - IMF

    An international organization created for the purpose of: 1. Promoting global monetary and exchange stability. 2. Facilitating ...
  6. Risk-Return Tradeoff

    The principle that potential return rises with an increase in risk. Low levels of uncertainty (low-risk) are associated with ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!