What Is the Difference Between Capitalization Rates and Overall Rate of Return?

Overall rate of return is a ratio between an investment's first-year return divided by its cost. In other words, it's an investment's first-year return on investment (ROI).

For real estate investors, this concept has a more specific name: the capitalization rate, or just cap rate. The cap rate is calculated exactly the same way as the overall rate of return, dividing the real estate investment's first-year net operating income by the acquisition cost of the property. In fact, the two concepts are so similar, some analysts will refer to the overall rate of return as the "overall capitalization rate" of the investment. Conventionally, both of these metrics are presented as percentages.

A more advanced understanding of ROI
In commercial real estate, the cap rate is one of the most critical factors when appraising a property. Consider the formula for calculating the cap rate:

Cap Rate (%) = Net Operating Income / Acquisition Cost

We can shuffle the equation around to be:

Acquisition Cost = Net Operating Income / Cap Rate

Therefore a commercial real estate appraiser can review recently sold properties that are comparable to the one in question, and compare how much investors were willing to pay for those properties relative to the income they produced. This is an effective, fast, and straightforward way for finding how much an investor can expect to pay for a given property.

The math works out so that a lower cap rate will yield a higher theoretical acquisition cost -- or, in this case, a higher appraised value.

In the real world, this could mean that a dilapidated apartment building with high tenant turnover could have a cap rate of 13%-15%. Just around the corner, though, a shopping center with several high-quality nationally recognized tenants could have a cap rate of 5%-7%. Even if these two properties generated the exact same net operating income, the nice shopping center would have a higher appraised value than the dilapidated apartment building.

Cap rates take into account risk and reward
The beauty of using cap rates to compare properties in this way is that an investor or appraiser can easily distinguish how the risk and reward profile of one property compares with those of other similar investments.

Fundamentally, real estate is like any other investment: Investors have to decide whether the potential returns justify the risk of buying a property. After all, an investor could simply put money in a nearly risk-free asset, like U.S. government Treasury bonds, and never worry about losing capital. As the risk rises, so must the reward.

The dilapidated apartment building is a riskier bet than the high-end shopping center. Assuming, again, that each property has an equal net operating income, we wouldn't want to pay the same amount to buy each property. The shopping center is a slam dunk, but investors want a higher rate of return on the apartment building to compensate for all the extra risk of the poor conditions and high tenant turnover. Therefore the apartment building would have a lower value than the shopping center, even though their net operating income is equal.

The cap rate of each property captures this risk-reward dynamic and presents it in an easy-to-understand ratio that we can use for comparison in our analysis of potential investments. When we see that one property has a significantly higher cap rate than another, we will immediately know that there must be some risk factors we need to understand before deciding to invest.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at knowledgecenter@fool.com. Thanks -- and Fool on!