In real estate finance, what is a 'cap rate'?

A cap rate, short for capitalization rate, is a critical financial metric used in real estate finance to assess the expected rate of return on an investment property. It is calculated by taking the net operating income (NOI) of a property and dividing it by the current market value or purchase price of the property. The resulting ratio provides investors with a percentage that reflects the potential yield they can expect to earn from their investment, assuming the property is purchased outright without financing.

This measure is particularly useful for comparing different properties or assessing the value of a property relative to its income-generating potential. A higher cap rate generally suggests a higher risk and potentially higher return, while a lower cap rate indicates a more stable, less risky investment with lower returns. Unlike the other options, this definition accurately describes the financial indicator that directly relates to investment performance in real estate.