Capitalization Rate (Cap Rate)

Capitalization Rate (Cap Rate)
A ratio used to estimate the return on investment of a real estate investment property, like an apartment building. It is calculated by dividing the income a property will generate in a given year (after fixed and variable costs) by the purchase price or current value of the property. For example, an apartment building that recently sold for $1,000,000 and generates $100,000 in income after expenses has a capitalization rate of 10%.

Capitalization Rate

One of the first equations you will come across in real estate investing is Capitalization Rate (CAP Rate). The CAP Rate simply looks at the potential return of the investment. The higher the percentage, the larger your return. In its simplest form, it looks at the ratio of gross yearly income generated divided by the cost (value) of the property:




Example:
For instance, if we located a $310,000 property that was expected to generate $2100/month in rent, our gross CAP Rate would be:


Real estate investors use the CAP Rate in a similar manner in which stock investors use the P/E Ratio*. These formulas allow for basic, quick calculations to be made to help a person quickly determine if an asset is priced at an attractive valuation.

On the surface, a company sporting a P/E Ratio below 10 usually looks to be cheap. Similarly, a CAP Rate of over 10% will look to be a good deal.