What is “Cap Rate”?
The capitalization rate, often referred to as the “cap rate”, is a fundamental concept used in the world of commercial real estate. It is the rate of return on a real estate investment property based on the income that the property is expected to generate. This metric is used to estimate the investor’s potential return on his or her investment.
The capitalization rate of an investment can be calculated by dividing the property’s net operating income (NOI) by the current market value or acquisition cost of a property – expressed in the following formula:
Capitalization Rate = Net Operating Income / Current Market Value
The cap rate is a ratio that gauges profitability. The proportion of NOI relative to the current market value must remain constant for the capitalization rate to remain the same. If NOI rises while the market value does not, the capitalization rate will rise and, if the opposite happens, the capitalization rate will decline.
For a real estate investment to remain profitable at a certain level, NOI needs to increase at the same rate as the property value increases, or at an even greater rate. In this respect, the capitalization rate can be beneficial in tracking a real estate investment over time to see if its performance is improving. If, for whatever reason, the capitalization rate is declining, it may be a wiser decision to simply sell the property and reinvest elsewhere.