The cap rate is used as a way to value income producing commercial properties. It is one of several considerations to be used when evaluating property.
The term "cap rate", short for capitalization rate, can be thought of as a "rate of return" or "interest rate". In other words, what rate of return or interest does the investor want to produce on their investment?
Different investments yield different rates, depending on risk. For instance, by putting money in the bank, it is expected to have a low rate of return, due to the fact that it is a less risky investment. With real estate investments, it is a high risk investment, therefore, a prudent investor expects a higher rate of return or cap rate.
The rate of return in real estate investments fluctuates, depending on current market conditions.
A formula is used to determine cap rate, by taking income minus expenses and turning them into a ratio which shows the amount of return on investment (cap rate) to estimate the value of the income producing property.