A Capitalization Rate is a real estate industry metric for the profitability of real estate holdings. It is defined as the expected Net annual Operating Income for a given property, divided by the purchase price of that property. For example, if a firm pays $10 MM for a building with annual operating income of $1 MM, the cap rate for that building is 10%.
A cap rate is a measure of how effectively a REIT's assets are generating cash flows, but it is more commonly used as a valuation technique when selling or acquiring properties.
REITs will commonly target a Cap Rate for their acquisitions - say, 8% - and then calculate how much they're willing to pay based on their estimate of the operating income the building will generate.
According to Property and Portfolio Research (as cited by General Electric and The Wall Street Journal), the median cap rate over the last 18 years was 7.5%.[1] Cap rates will often fall during a real estate boom - on the assumption that rents will increase, and that the value of the property will go up - and rise during real estate downturns, as acquirers demand lower purchase prices to compensate for the risk that prices or rents could fall further.
References
- ↑ [http://online.wsj.com/article/SB124051515422749193.html Wall Street Journal, "If the Cap Rate Doesn't Fit, Bank Investors Will Have to Wear It Anyway", April 24th 2009.
