What is a cap rate?
Wednesday, September 24th, 2008A cap rate, or capitalization rate, is an expression of return calculated as follows:
Net Operating Income/Purchase Price = capitalization rate
A cap rate does not take into accout return over time, as it only focuses on one year’s income.
As such, to only evaluate a real estate investment by looking at its cap rate is foolish. What does the 2nd year’s income look like? The 10th year’s income? Where are rental rates in place compared to market? Are you paying more or less than it costs to replace the building? What will cash on cash returns look like after the property is financed? What is the internal rate of return after a 5 or 10 year hold?
