What is Cap Rate (Capitalization Rate)?
The Short Answer
Cap Rate (Capitalization Rate) explained simply
The Cap Rate is a simple way to look at how much income a property might generate compared to its price. It's a common tool in real estate to quickly size up a deal. Think of it as a snapshot of the property's income-generating ability. It doesn't factor in debt, so it's a pure look at the property's operational income versus its cost.
Real-World Example
The Apartment Building Deal
Let's say an apartment building is for sale at $1,000,000. It brings in $100,000 in Net Operating Income (NOI) each year.
To find the Cap Rate, you divide the NOI by the purchase price:
$100,000 (NOI) / $1,000,000 (Purchase Price) = 0.10 or 10%
So, the Cap Rate for this building is 10%. This means for every dollar you invest, you could expect a 10-cent return each year, before considering any loan payments.
Why this matters
Understanding the Cap Rate helps you compare different investment properties. A higher Cap Rate might mean a better return, but it could also signal higher risk. A lower Cap Rate often means lower risk and a more stable investment. It's a quick way to see if a property fits your investment goals.
Don't just look at the Cap Rate in isolation. Always compare it to similar properties in the same area. A high Cap Rate in a bad neighborhood might not be as good as a lower Cap Rate in a prime location.
Don't just look at the Cap Rate in isolation. Always compare it to similar properties in the same area. A high Cap Rate in a bad neighborhood might not be as good as a lower Cap Rate in a prime location.
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