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Capitalization Rate or Cap Rate - is the annual return on an investment before mortgage payments and income taxes. The income-capitalization approach to home valuation is that rent (income) minus expense, divided by investment (sales price) equals the return on investment (capital).
This return on capital is commonly referred to as a "cap rate" and is analogous to the percentage of return received on other investments like stocks, bonds or treasury bills. Example: a building with a cap rate of 9 percent on a $1 million investment would be expected to generate a return of $90,000 per year.
The capitalization rate or "cap" rate for a property is determined by dividing the property's net operating income by its purchase price. Generally, high cap rates indicate higher returns and a perceived increased risk.
Cap Rate formula: Cap Rate = Net Operating Income / Market Value x 100.
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