Capitalization rate (cap rate) is perhaps the most commonly used indicator of the expected return on a property investment. A cap rate for a property is calculated by dividing the annualized net income of a property by its price (or property value), which is expressed as a percentage. For example, a property listed for $1m that produces $50k in net income annually would have a 5% cap rate. The cap rate expresses the percentage of the property’s value that is returned to the owner each year in income.
Just as riskier stocks will generally have higher dividends relative to blue chip properties, a low-income apartment complex is generally going to have a much higher cap rate than a apartment complex in Beverly Hills. Because the cap rate is so ubiquitous to the value of investment property, an investor can readily add value to their property by successfully increasing rents even for a few percentage points. Likewise, decreasing the annual costs of insurance, utilities, property management fees, maintenance costs or any other operating costs will increase the cap rate and ultimately the market value of the property.