By definition, a capitalization rate is used to evaluate how long an investment will take to pay for itself. This is accomplished by dividing a property‘s net operating income by its current market value or sale price. The capitalization rate, commonly referred to as the “cap rate,” is calculated as the ratio of a property's net operating income divided by its current market value, expressed as a percentage. It is a measure of the potential return on an investment and can be used to compare the relative value of different investments.

For example, if a property generates an annual net operating income of $50,000 and the current market value of the property is $500,000, the cap rate would be 10 percent. Put another way, if an investor purchased the property for that price, they would expect to receive a 10 percent return on their investment. The higher the cap rate, the higher the potential return on investment.

The cap rate doesn't consider the term of the investment. That is why it is important to consider other factors when evaluating real estate investments such as financing costs, taxes, and potential cash flow.

The cap rate for a particular investment is determined by analyzing a variety of factors such as location, the local economy, property type, and the current level of demand for the property. In addition, investors can also use the cap rate to estimate the sale price of a property. This can be done by taking the net operating income and dividing it by the desired rate of return.

In conclusion, the capitalization rate is a vital tool when evaluating real estate investments. It offers investors insight into the potential returns they can expect to receive. While it is one of many factors to consider when making an investment decision, its ability to measure relative value makes it a powerful tool in the investor's toolbox.