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. Perpetuity

    A constant stream of identical cash flows with no end. The formula ...
  2. Interest Rate

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

    1. In accounting, it is where costs to acquire an asset are included ...
  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 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. Investing Basics

    The Strange New World Of The Bitcoin Exchange Futures Market

    We explain the basics of the Bitcoin exchange and futures market.
  6. Fundamental Analysis

    What are the most common issues with Serial Correlation in stocks?

    Read about the concept of serial correlation in stock returns, and learn why market analysts are divided about the efficacy of trading based on stock patterns.
  7. Investing Basics

    What is the difference between a REIT and a master limited partnership

    While both are prized for their dividends by income investors, there are notable differences between REITs and master limited partnerships (MLPs).
  8. Credit & Loans

    What are the pros and cons of owning an equity REIT versus a mortgage REIT?

    Learn about investing in equity, mortgage and hybrid REITs. Explore the different strategies REITs employ to generate income and create dividends.
  9. Investing Basics

    What is the difference between a REIT and a real estate fund?

    A real estate fund invests in securities offered by public real estate properties directly or indirectly through Real Estate Investment Trusts (REITs).
  10. Bonds & Fixed Income

    How do I calculate yield to maturity of a zero coupon bond?

    Find out how to calculate the yield to maturity for a zero coupon bond, and see why this calculation is more simple than a bond with a coupon.

You May Also Like

Hot Definitions
  1. Weather Insurance

    A type of protection against a financial loss that may be incurred because of rain, snow, storms, wind, fog, undesirable ...
  2. Portfolio Turnover

    A measure of how frequently assets within a fund are bought and sold by the managers. Portfolio turnover is calculated by ...
  3. Commercial Paper

    An unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories ...
  4. Federal Funds Rate

    The interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution ...
  5. Fixed Asset

    A long-term tangible piece of property that a firm owns and uses in the production of its income and is not expected to be ...
  6. Break-Even Analysis

    An analysis to determine the point at which revenue received equals the costs associated with receiving the revenue. Break-even ...
Trading Center