What is a cap rate in real estate?

A cap rate, or capitalization rate, is a crucial metric in real estate that provides a quick assessment of the potential return on an investment property. Specifically, it is calculated by taking the Net Operating Income (NOI) of a property and dividing it by the property's purchase price or current market value. This ratio expresses the expected annual return as a percentage of the property’s value, helping investors gauge the profitability and risk associated with different real estate investments.

Using this metric allows investors to make informed decisions by comparing the cap rates of various properties. A higher cap rate indicates a higher potential return, albeit often with increased risk, while a lower cap rate suggests a safer investment with possibly lower returns.