Cap Rate (Capitalization Rate)
Definition
The ratio of a property's net operating income to its purchase price, used to estimate the potential return on a real estate investment. Higher cap rates suggest higher returns but may indicate more risk.
The capitalization rate is the fundamental valuation metric in real estate investing. It's calculated by dividing the property's Net Operating Income (NOI) by the purchase price. A property generating $50,000 in annual NOI purchased for $500,000 has a 10% cap rate.
Cap rates serve the same function as P/E ratios in stock investing — they help compare properties and assess whether an investment is fairly priced. Lower cap rates indicate more expensive markets (investors accept lower returns), while higher cap rates suggest cheaper markets or higher risk.
Typical cap rates vary significantly by property type and location. Prime urban office buildings might trade at 4-5% cap rates. Suburban apartments at 5-7%. Retail properties at 6-9%. Rural or distressed properties at 8-12%+. The range reflects the perceived risk, growth potential, and quality of each market segment.
Cap rate does not account for financing — it assumes an all-cash purchase. The actual return to an investor using mortgage leverage will differ from the cap rate. It also doesn't capture appreciation, renovation potential, or tax benefits, making it just one factor in a complete real estate analysis.
For REIT investors, cap rates help assess whether a REIT is buying properties at fair valuations. If a REIT consistently acquires properties at cap rates above its cost of capital, it's creating value for shareholders.
Where this appears in Clarity
Clarity automatically tracks and calculates these concepts across your connected accounts.
Related Terms
Frequently Asked Questions
What's a good cap rate?
It depends on the property type, location, and market conditions. Generally, 5-10% is a common range. Lower cap rates (4-6%) are typical for prime locations with stable income. Higher cap rates (8-12%) may indicate higher risk or less desirable locations. Compare cap rates within the same property type and market.
Does cap rate include mortgage payments?
No. Cap rate is based on net operating income before debt service, assuming an all-cash purchase. It measures the property's return independent of how it's financed. Your actual cash-on-cash return with a mortgage will be different (potentially higher due to leverage).