In real estate, the capitalization rate—commonly known as the cap rate—is a fundamental metric used to evaluate the potential return on an investment property. It represents the ratio between a property's net operating income (NOI) and its purchase price or current market value. The formula is simple:

Cap Rate = Net Operating Income ÷ Property Value

For example, if a property generates $50,000 annually in net income and is worth $500,000, its cap rate is 10%.

Cap rates help investors compare the profitability of different real estate investments, regardless of their price or size. A higher cap rate generally indicates a higher potential return—but also possibly higher risk or a less desirable location. Conversely, a lower cap rate may reflect a more stable or premium asset in a sought-after area, often with lower risk but also lower expected return.

It's important to note that cap rate is just one tool in an investor's toolbox. It doesn't account for financing costs, tax implications, or future property appreciation. However, it provides a quick snapshot of a property's earning potential and can guide decision-making in the early stages of evaluating an investment.