There are many definitions of the word cap. One would be the literal accessory that we wear on our heads. Another would be the lid or stop-cork for a bottle or anything to seal something. However, one more meaning of cap is essential in this context and that is the limit or restriction that is applicable. It also means capitalization, i.e. the market cap of an entity is its total capitalization on the bourses at any given moment.
The definition of cap in a real estate context should be through the capitalization rate. This is also commonly called the cap rate. This rate helps in assessing any investment in real estate. The formula for the cap rate is the following-
Cap Rate = Net operating income/current market value (selling price) of the real estate asset.
The Cap rate or capitalization rate indicates the prospective return rate for any investment in real estate. The higher this rate, the better your chances of earning good returns as a real estate investor. The net operating income is one of the key parameters for computing this ratio and this can be calculated through the deduction of all the operating expenses from the asset’s gross operating income. By operating expenses, we mean property maintenance, taxes and other payables in a year. This will not cover depreciation though. The capitalization rate is the best way to indicate how investment-worthy any real estate asset actually is.
It also helps in drawing a comparison between various opportunities for investments in properties. Any property with a cap rate of 5% will naturally be better than one with a cap rate of 1% for instance. The rate also indicates the time required for recouping the investment. A 5% cap rate indicates that the investor will need at least 5 years to recoup his/her investment. Cap rate is however not the only measure for analyzing returns on property investments. This is because lower cap rates are sometimes indicative of lower risk levels. Hence, there is no ideal cap rate that investors can depend on. These are some aspects worth noting in this regard.
