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. How are American Depository Receipts (ADRs) exchanged?

    American depositary receipts (ADRs) are bought and sold on regular U.S. stock exchanges, either in the over-the-counter market ... Read Full Answer >>
  6. What is the difference between adjusted and regular funds from operations?

    While regular funds from operations measures the cash flow generated by the operations of a real estate investment trust ... 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. Bonds & Fixed Income

    What are Floating-Rate Notes?

    A floating-rate note is a debt instrument with an interest rate that “floats,” or varies. They are also called floaters.
  6. Mutual Funds & ETFs

    Top 3 ETFs For Investing in Brazil

    Discover information and analysis of some of the most popular and best performing exchange-traded funds that offer investors exposure to Brazil.
  7. Entrepreneurship

    How Grant Cardone Built a $350M Real Estate Empire

    Sales trainer Grant Cardone built his multimillion-dollar real estate empire without raising external capital from anyone beyond his close family members, who own less than 2% of the Cardone ...
  8. Investing

    Where Are Real Estate Stocks Heading?

    We summarize five economic reports that investors should monitor monthly to keep them informed of where real estate and its related stocks are heading.
  9. Investing

    Looking for Alternatives to Invest in Real Estate?

    There are several ways to invest in “real estate” via the stock market, buying stocks and hold them for years. We give you 5 ways to invest in real estate.
  10. Investing

    Five Portfolio Moves For The Second Half

    After a relatively calm few months, market volatility is back. If you are an investor, we help you prepare your portfolio with these five portfolio moves.

You May Also Like

Hot Definitions
  1. Investopedia

    One of the best-known sources of financial information on the internet. Investopedia is a resource for investors, consumers ...
  2. Unfair Claims Practice

    The improper avoidance of a claim by an insurer or an attempt to reduce the size of the claim. By engaging in unfair claims ...
  3. Killer Bees

    An individual or firm that helps a company fend off a takeover attempt. A killer bee uses defensive strategies to keep an ...
  4. Sin Tax

    A state-sponsored tax that is added to products or services that are seen as vices, such as alcohol, tobacco and gambling. ...
  5. Grandfathered Activities

    Nonbank activities, some of which would normally not be permissible for bank holding companies and foreign banks in the United ...
  6. Touchline

    The highest price that a buyer of a particular security is willing to pay and the lowest price at which a seller is willing ...
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!