Capitalization Rate

The Capitalization Rate (or cap rate) is a calculation that allows investors measure the earning ability of an real estate investment property. It is a ratio between a real estate investment property's net operating income and it's purchase price. The capitalization rate is also called the net yield.

Cap rates may vary in different areas of a city for many reasons such as desirability of location, level of crime and general condition of an area. Investors expect larger returns when investing in high risk real estate investment properties. If you would like to find out what the cap rate is for a particular type of real estate investment property in a given market, check with an appraiser or lender in that area. Since the frequency of sales for commercial real estate investment properties in a given market place may be low, reliable cap rate data may not be available. If you are able to obtain cap rate data from an appraiser or lender for the type of real estate investment property you are evaluating, check to see if the cap rate value was determined with recent sales of comparable real estate investment properties or if it was constructed.

Note: The interest expenses (mortgage payments) are not deducted from the income when calculating the capitalization rate, that's mainly because this indicator measures the earning ability of the real estate investment property regardless of how you finance it. Interest expenses are excluded so that the valuation of the real estate investment property does not depend on the amount of debt used to purchase the real estate investment property.

The higher the cap rate the better, as this is the money that really flows into your pocket. Some investors would not go for a cap rate lower than 7%.
You can use the cap rate to: ��
1. Compare against other real estate investment properties (which real estate investment property gives higher cap rate at the same outlay amount?) ��
2. Compare against other real estate investment properties, and ���
3. Measure the earning ability of a real estate investment property.

You should always try to purchase a real estate investment property with a higher cap rate.