Cap rate is one of the more popular rates of return used by investors to determine the profitability of real estate income property.
Actually, the term cap rate is really just a friendly name for its more imposing real name, capitalization rate. So whether you prefer to use the real name or the friendly name is up to you. Both are acceptable, though most real estate agents and investors refer to it quite comfortably as cap rate.
Technical Interpretation
Capitalization rate is the rate at which you discount future income to determine its present value. But this is difficult to explain, so we’ll consider what cap rate actually means in practice. It will give you the idea.
What Cap Rate Means in Practice
Cap rate is mostly used by investors to determine the relationship between a property’s net operating income and its value. In other words, it expresses what percentage rate a property’s net operating income is to its value (or sale price).
What Makes Cap Rate Popular?
1. Easy way to compare similar properties in the area
2. Easy way to calculate a reasonable estimate of property value
3. Easy way to calculate a property’s net operating income
There is no one ideal cap rate. It varies from area to area and from investor to investor. Nor does cap rate alone provide a true picture of a property’s profitability. But it is a rule of thumb that provides a first-glance assessment of a property’s ability to pay its own way.
