Definition of Capitalization rate:
Business valuation: Reciprocal of the desired rate of return multiplied by the normalized earnings of a business to arrive at its purchase price.
General: Discount (or interest) rate used to determine the present value of a series of future earnings from an investment.
The capitalization rate (also known as cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. This measure is computed based on the net income which the property is expected to generate and is calculated by dividing net operating income by property asset value and is expressed as a percentage. It is used to estimate the investor's potential return on their investment in the real estate market.
While the cap rate can be useful for quickly comparing the relative value of similar real estate investments in the market, it should not be used as the sole indicator of an investment’s strength because it does not take into account leverage, the time value of money and future cash flows from property improvements, among other factors. There are no clear ranges for a good or bad cap rate, and they largely depend on the context of the property and the market.
Real estate: Ratio of rental income from a property to its market value, expressed as a percentage. This rate is used in comparing rate of return from a property with the rate of return from alternative investments.
How to use Capitalization rate in a sentence?
- This ratio, expressed as a percentage, is an estimation for an investor's potential return on a real estate investment.
- Capitalization rate is calculated by dividing a property's net operating income by the current market value.
- Cap rate is most useful as a comparison of relative value of similar real estate investments.
Meaning of Capitalization rate & Capitalization rate Definition