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Capitalization
Rate (CAP Rate)
In real estate
appraisal, capitalization is the process of converting income,
in the
case of real estate net
rental income, to a
property value.
The
capitalization rate or CAP Rate for short, is the ratio of
yearly net
income to the property value. For example,
if you purchase an investment property for $120,000 dollars
and can generate $1,000
per month
after all
operating expenses (before debt service),
then the CAP Rate would be $12,000 divided by $120,000 or 10
percent. This means it will take approximately 10 years to
recoup the property value in net
rental income assuming the rent stays the
same.
In
general, the lower
the CAP Rate the better
if you
are selling and the higher the CAP Rate the better if you are
buying. However, make sure the
neighborhood is good and the property is in decent condition.
CAP Rate does not
help if the
property is declining in value.
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