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Also known as a capitalization rate, the cap rate is a discount rating that is used to determine the current or present value of the accumulated assets that will create future earnings. Utilized in both projecting revenue for a business over a period of time and in evaluating the rate of return on a mortgage, the cap rate normally is calculated income taxes are extracted net income. The cap rate is generally determined by dividing the net operating income associated with the enterprise by the market value times one hundred.
Calculating the current cap rate is an excellent means of ensuring that the business or investment is actually continuing to yield a return. In the best of circumstances, the hope is that the cap rate will demonstrate a relatively risk free return and possibly even a premium over time. However, the cap rate can also be used as an indicator that the investment has some potential problems. When the cap rate does not demonstrate a rate of return that is considered equitable, an investor can choose to pass on the investment and seek a different opportunity.
The business can also benefit from the calculation of cap rates. If the cap rate does not indicate a strong performance, then the owners and managers of the corporation can examine the factors involved. This can lead to making important changes that can help the corporation to improve the bottom line and thus make an impact on the net operating income. Improved performance will also help the overall market value of the company.
As a simple ratio that is used to create an estimate of the value of revenue producing entities, the cap rate is valuable as a means of helping a company improve the bottom line. At the same time, the cap rate serves as an excellent source of information for an investor, making it possible to identify opportunities that carry a lower risk to a capital investment.
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