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The percentage selected for use in the income approach to valuation of improved property. The CAP rate is designed to reflect the recapture of the original investment over the economic life of the improvement to give investors an acceptable rate of return (yield) on their original investments and to provide for the return of the invested equity. In other words, if the property includes a depreciating building, the CAP rate provides for the return of invested capital in the building by the end of the economic life (the recapture rate that allows for the building’s future depreciation) and the return on the investment in the land and the building (similar to yield).

Example: If a building has a 50-year economic life, then the recapture rate is set at 2 percent per year. If the rate of return on the investment is 8 percent and the recapture rate is 2 percent, then the overall capitalization rate applicable to the building is 10 percent.

An appropriate CAP rate is influenced by the conditions under which the particular investment is being operated, as well as the availability of funds, prevailing interest rates, and risk. If the property earns $100,000 per year and the cap rate is 9 percent, then determining what the property is worth to the investor is as follows: $100,000 ÷ 0.09 = $1,111,111. Only an experienced appraiser can select the appropriate CAP rate—a mere 1 percent difference in the suggested CAP rate could make a 12 percent difference in the value estimate.
The CAP rate measures the risk involved in an investment; thus, the higher the risk, the higher the CAP rate; the lower the risk, the lower the CAP rate.
Dearborn Real Estate Education
This "Word of the day" is excerpted from The Language of Real Estate, 6th Edition by John Reilly (published by Dearborn Real Estate Education, 2006 copyright). To purchase the complete book, with over 2800 key terms and definitions, or to browse through Dearborn's hundreds of other professional real estate titles, including Real Estate Technology Guide by Klein, Barnett, Reilly, click here.