Cap rate
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A contraction of capitalization rate, the cap rate is the assumed rate of return on an investment in real estate. The cap rate is commonly used in the valuation of commercial and investment property because it directly links the value to the income produced by the property.
To determine the value of a particular real estate asset, divide the net income or the net cash flow on the asset by the assumed cap rate. Effectively, this values the real estate as a perpetuity.
An alternative use of the concept is to take the net income or net cash flows, and divide it by the purchase price in a sales transaction, to determine the implied cap rate. Used in this fashion, the cap rate indicates rising or falling demand for real estate investments.
Note that a higher cap rate results in a lower value. Thus, newer properties in upscale areas will tend to show lower cap rates than their less desirable counterparts.