What is a cap rate in real estate?

A cap rate, or capitalization rate, is fundamentally a ratio that helps investors estimate the potential return on investment in real estate. It is calculated by dividing the net operating income (NOI) of a property by its current market value or acquisition cost. The resulting percentage gives investors a useful benchmark for comparing the profitability of various real estate investments.

For example, a property with a net operating income of $50,000 and a market value of $500,000 would have a cap rate of 10%. This indicates that the investor could expect a return of 10% on their investment, not taking into account factors such as financing, taxes, or future appreciation.

Understanding the cap rate is critical for investors as it can influence purchasing decisions and overall investment strategies, particularly in assessing how well a property is performing compared to others in the market. It serves as a quick and effective way to gauge the relative value of a property based on its income potential.