A cap rate, also known as a capitalization rate, is an underlying concept that is used in the world of commercial real estate. To further explain, a cap rate is the rate of return on a real estate investment property based on the income that the property is expected to generate. The cap rate is an extrememly useful tool when comparing specific real estate investment opportunities.
How is a cap rate calculated?
A cap rate is calculated by dividing a property’s net operating income (NOI) by its current market value. This formula can be expressed as:
NOI / Current market value = Cap Rate
What does rate of return mean?
The rate of return on an investment property is the income that an owner has the potential to profit from. The potential rate of return of an investment can be measured in either absolute terms (dollars and cents) or as a percentage of the amount invested.
This profit is expressed as a portion of the original investment over a period of time. A rate of return is typically based on a one year or annual period, and a rate of return is often referred to as an annual return.
A return on investment or ROI is a measure of investment performance based on the return per dollar invested. The formula for ROI is as follows:
(Gain from Investment – Cost of Investment) / Cost of Investment = ROI
Can a rate of return be applied to property that is not real estate?
A rate of return can be applied to any investment property. This means that an asset has to be purchased and then at some point in the future, generate a cash flow for the owner that is larger than the initial price they purchased the asset for. Examples of property that a rate of return can be applied to include but are not limited to:
- Precious stones
- Fine art
- Real estate
What is discounted cash flow?
Discounted cash flow is a method that investors use to estimate the attractiveness of a potential investment opportunity. The discounted cash flow uses future free cash flow projections and then discounts them using a required annual rate to see present value estimates. That present value estimate is then used to weigh the potential for the investment. The main goal of discounted cash flow is to analyze if the investment makes sense. If the value derived through discounted cash flow is higher than the current cost of the investment, the opportunity may be a good investment.