We are often asked about the capitalization rate and how it is used in real estate. A cap rate is a simple metric that defines return on capital and is the rate at which income capitalizes an asset’a current price or value. The cap rate is the ratio of Net Operating Income (NOI) to property current asset value. Value (V) equals net operating income(NOI) divided by the capitalization rate (r). If a property was listed for $1,500,000 and generated an NOI of $120,000, then the cap rate would be eight percent which is $120 ,000/$1,500,000.
The cap rate is a ratio gauging profitability, the proportion of NOI relative to the current market value must remain constant in order for the capitalization rate to remain the same. If NOI rises while the market value does not, the cap rate will rise and, if the reverse happens, the cap rate will decrease. Capitalization rates are often useful because it’s a simple calculation to gauge value.
The capitalization rate is also a good starting point in determining value because it can be used to quickly and easily compare many investment opportunities with one another. Other important factors in determining value include the sales comparison, cost approach and the more in depth capital asset pricing model.
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