What does "capitalization rate" measure in real estate?

Capitalization rate, often referred to as "cap rate," is a critical concept in real estate that measures the rate of return on an investment property based on the income it generates. It is calculated by taking the net operating income (NOI) of the property and dividing it by the property's current market value or sale price.

A higher cap rate generally indicates a potentially higher return on the investment relative to its price, making it an essential tool for investors to assess the viability of a property as an investment. The cap rate provides a quick and effective way to compare different real estate investments, helping investors make informed decisions based on expected profitability.

This metric does not directly relate to interest rates for loans or the value of a property after any depreciation has been accounted for. While understanding the difference between purchase and sale prices is important, that information reflects the profitability of a specific transaction rather than assessing the ongoing income-generating capability of a property. Cap rates focus specifically on ongoing income and are crucial for evaluating the long-term investment potential of real estate assets.