Capitalization Rate – better known as cap rate – may sound like your typical finance jargon, but it is arguably the most important term in commercial real estate.
Capitalization Rate = Net Operating Income / Asset Value (or Purchase Price)
Cap rate, simply put, shows an investor the rate of return on their real estate investment. Many investors target a specific cap rate range, particularly when purchasing with a debt component.
The primary use of cap rate is to determine potential return on investment, but it can also be an indicator into market strength. Markets with less economic activity tend to reflect a higher cap rate.
Additionally, cap rate indicates the duration of time it will take to recover one’s investment. For example, a property with a cap rate of 10% will take around 10 years to make back the initial investment.
Investor’s should take a comprehensive approach and not just rely on cap rate. While a return on investment of 7% may seem like a no-brainer, higher returns intrinsically mean higher risk.