Capitalization rate
National Real Estate Exam glossary · Valuation
Definition
The rate of return an investor requires on a real estate investment, used to convert a single year's net operating income into a value estimate. In the IRV relationship, Value = Income div Rate; the cap rate moves inversely with value, so a higher required rate produces a lower value for the same income.
Capitalization rate in plain English
The capitalization rate (cap rate) is a quick way investors size up how much a money-making property is worth based on the yearly profit it throws off. The core idea is Value = Income div Rate, where 'income' is the yearly profit after expenses and 'rate' is the return the investor demands. Here's the twist: if you insist on a bigger return for the same yearly income, the price you're willing to pay actually drops — a riskier bet has to be cheaper to be worth it. It's like judging a lemonade stand: if it earns $100 a year and you want a 10% return, you'd pay $1,000 (100 div 0.10); demand 20% and you'd only pay $500 for that same stand.
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