How Are Current Cap Rates Used in the Real Estate Industry?


Quick Answer

Current capitalization rates, also known as cap rates, appear in the real estate industry as a simple way to measure the potential return on investment for a property, as well as identifying potential trends in a particular market segment. The cap rate comes from dividing the property's current value by its annual net operating income, thus appearing as a percentage value.

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Full Answer

Real estate agents and investors often use cap rate as a method for understanding the revenue potential on an investment without conducting an in-depth analysis of its finances, as it essentially represents the amount of money the investor can make back each year after purchasing it. For example, if a real estate agent estimates the value of a restaurant space at $1,000,000, and the business reports a net annual income of $50,000, then it has a cap rate of five percent, which she may then compare against another property with a higher cap rate to decide its value to her.

Real estate professionals also look at cap rates across multiple properties within a specific segment to identify trends and make other decisions in relation to the market. If a real estate inventor sees that cap rates for residential apartment buildings in an area increase year after year, she may decide to invest in buildings in that area. However, the cap rate does not account for fluctuations in income or other long-term issues, and thus does not provide a full picture in any scenario.

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