4/3/12 Printable Definition | Investopedia

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Filed Under Alternative Investments , Financial Theory , Fixed Income , Mortgages , Real Estate
, Taxes
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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".
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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.