Capitalization rate, more known as “Cap Rate'' is the one of the most widely used real estate terms. Simply, it is the percentage of net operating income (NOI) relative to the purchase price. The formula to calculate the cap rate is: NOI / Current Market Value = Cap Rate.
The calculation is quite simple, but cap rates can vary depending on the asset type, location, and state of the overall market. Cap rates are a good metric for return only when dealing on a cash basis. When you are analyzing a real estate purchase with debt, one should also consider internal rate of return (IRR), Levered IRR, Cash on Cash, and Equity Multiple.
Cap rates are the quickest way to compare similar properties in an area. They can also be utilized to spot trends of a particular asset class. Generally speaking, if cap rates are trending higher, that means the price of the asset has been decreasing. On the other hand, asset prices that are rising will mean cap rates are compressing. There is an inverse relationship between price and cap rate.
Another way to utilize a cap rate is to quickly assess an asset's risk. In theory, a lower cap rate asset will have less associated risk.
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