What does the capitalization rate approach measure in real estate?

The capitalization rate approach is a crucial concept in real estate valuation, particularly for investment properties. It measures the relationship between a property’s net operating income and its value by using the formula where the net operating income is divided by the capitalization rate. This approach provides a way for investors to assess the return potential of an investment property relative to its current market price or value.

By utilizing this method, an investor can determine the expected rate of return on their investment based on the income the property generates after expenses, giving a clear insight into the property's profitability. This is especially useful when comparing similar investment opportunities and aids potential buyers in making informed decisions based on expected income rather than solely on sales prices or physical characteristics.

Understanding how to calculate and interpret the capitalization rate is essential for anyone involved in real estate investment as it helps in evaluating whether the property meets their financial criteria.