What does the cap rate measure in real estate?

The capitalization rate, or cap rate, is a fundamental metric in real estate that specifically measures the relationship between a property's net operating income (NOI) and its value or purchase price. It is expressed as a percentage and is calculated by dividing the NOI by the property's value. The cap rate provides investors with insight into the expected return on investment and helps in comparing the profitability of different real estate assets.

For instance, a higher cap rate typically indicates a higher potential return, which can reflect increased risk, while a lower cap rate may suggest a more stable, lower-risk investment with lower potential returns. This measure is essential for investors trying to assess whether a property is priced appropriately relative to the income it generates. Understanding the cap rate allows investors to make informed decisions based on income potential and market conditions.