Please explain cap rate

[Sylvia B.]

First let me be sure I understand what it is.

Capitalization Rate = Yearly Income/Total Value

Now right here I already have a problem. I would expect "Total Value" to be what it cost me, but apparently I'm mistaken. Here is an example I read:

"For example, if Steven buys a property that will generate $125,000 per year and he pays $900,000 for it, the cap rate is: 125,000/900,000 = 13.89%."

So far, so good, but it continues:

"But it gets a little more complicated. What if the property's value rises to $2 million two years later? Now the cap rate is a less favorable 125,000/2 million = 6.25%."

So if I have a property that I over-improved, it seems to me that the cap rate would be a useless number. Say I buy a property for 50k, put 50k into improvements and other costs, and the yearly income is 10k. That should equal a cap rate of 10%. However, the market value of the property is only 75k. Using that number gives a cap rate of 13.3%.

This doesn't make sense to me. What am I missing?

Secondly, is the cap rate useful for comparing different kinds of investments? For instance, is it meaningful to compare a cap rate on a 100k RE investment with a return on a 100k mutual funds investment? If not, what does it really tell me?

[Ramon Jenkins]

@Bryan Hancock thanks for tip

@Sylvia B. here the link deriving cap rate