What does the term 'cap rate' indicate in real estate?

The term 'cap rate,' short for capitalization rate, is a fundamental concept in real estate investing, specifically in valuing income-producing properties. It indicates the rate of return on an investment property based on the income it generates, essentially serving as a measure of its profitability.

To calculate the cap rate, one divides the net operating income (NOI) of a property—what it earns after expenses—by the current market value or purchase price of the property. This percentage helps investors assess the potential return on their investment and compare the profitability of different properties or investment opportunities.

Understanding cap rate is crucial for making informed investment decisions, as it provides insights into how much income an investor can expect relative to their investment. A higher cap rate may suggest a higher return on investment, which often comes with higher risk, while a lower cap rate might indicate a safer investment with more stable returns. Thus, the cap rate directly links the income aspect of property ownership with its valuation in the marketplace.