In real estate, the capitalization rate, or cap rate, is used to show the expected rate of return on an investment property. It is expressed as a percentage of the initial purchase price and indicates its net gain or loss over a one-year time frame.
Mortgage or financing costs are excluded from the cap rate calculation. By not including financing costs in the cap rate, investors can make a better apples-to-apples comparison of similar properties in the same area, because how a property is financed and the amount of leverage used varies from one investor to the next.
All else equal, the higher the cap rate, the superior the investment. However, a higher cap rate isn’t always better. For example, higher cap rates are often achieved by investing in riskier properties, so there is a tradeoff between risk and return.
Higher Cap Rate: If a property is perceived to have higher risk, an investor will demand a higher return, which means they will pay a lower price. This results in a higher cap rate.
Lower Cap Rate: If a property is perceived to have lower risk, the investor may require a lower return on investment, which means they will pay a higher price. This results in a lower cap rate.
Cap rate is not a perfect metric by which an investment decision can be made in isolation, but when combined as a key metric among several formulations and perspectives, it can help investors make the right decisions for their portfolio.
