cap rate
Short for capitalization rate — the ratio of a property's net operating income to its purchase price, used to estimate the return on a real estate investment.
Example
“A rental property generating $40,000 per year and purchased for $500,000 has an 8% cap rate.”
Memory Tip
Cap rate = how fast income covers the purchase price — higher is better.
Why It Matters
The cap rate helps real estate investors quickly compare whether different properties offer good returns relative to their purchase price. Understanding cap rates allows you to evaluate investment opportunities more objectively and avoid overpaying for properties that do not generate sufficient income.
Common Misconception
Many people mistakenly believe a higher cap rate always means a better investment, but this ignores risk factors. A property with a very high cap rate may have that rate precisely because it is riskier, located in a declining area, or requires significant repairs and management challenges.
In Practice
Suppose you are considering buying a rental property for 500,000 dollars that generates 30,000 dollars in annual net operating income. The cap rate would be 6 percent (30,000 divided by 500,000). If another property costs 400,000 dollars but only generates 20,000 dollars in net operating income, its cap rate is 5 percent, making the first property the better investment based on this metric alone.
Etymology
Shortened from 'capitalization rate' — how quickly the property capitalizes its cost through income.
Common Misspellings
Compare today's mortgage rates
Related Terms
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See Also
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