Legal Definitions - cap rate

Definition: Cap rate, short for capitalization rate, is a financial metric used to evaluate the profitability of a real estate investment. It is the ratio of the property's net operating income (NOI) to its current market value or purchase price.

Example: Let's say you are considering purchasing a rental property for $500,000. The property generates an annual net operating income of $50,000. To calculate the cap rate, you would divide the NOI by the purchase price: $50,000 ÷ $500,000 = 0.10 or 10%. This means that the property has a cap rate of 10%, indicating that it is a profitable investment.

Another example would be if you were comparing two different properties. Property A has a purchase price of $1,000,000 and generates an annual NOI of $100,000, resulting in a cap rate of 10%. Property B has a purchase price of $2,000,000 and generates an annual NOI of $150,000, resulting in a cap rate of 7.5%. Even though Property B generates more income, Property A has a higher cap rate and may be a more profitable investment.

The examples illustrate how cap rate is used to determine the profitability of a real estate investment. A higher cap rate indicates a higher return on investment, while a lower cap rate indicates a lower return on investment. It is important to consider the cap rate when evaluating potential real estate investments.