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If capitalization rate is the value of the property divided by the net return, how is that different from the net profit margin?

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"Capitalization rate" and "Net Profit margin" are two different things. In Capitalization rate note that we are taking the "total value" in the denominator and in Net profit margin we are taking "Revenue/Sales".

Capitalization Rate:

Capitalization Rate = Yearly Income/Total Value

For example (from Investopedia: )

if Stephane 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%.

Net Profit margin:

Net Profit margin = Net Profit/Revenue

For example (from finance formulas):

A company's income statement shows a net income of $1 million and operating revenues of $25 million. By applying the formula, $1 million divided by $25 million would result in a net profit margin of 4%. Although the formula is simplistic, applying the concept is important in that 4% of sales will result in after tax profit.

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Both of these terms do refer to your profit; they're just different ways of evaluating it.

First, your definition of capitalization rate is flipped. As explained here, it should be:

cap rate = net yearly return / property value

On the other hand, as explained here:

net profit margin = net yearly return / yearly revenue

So cap rate is like a reverse unit cost approach to comparing two investments. If house A costs $1M and you'll make $50K (profit) from it yearly, and house B costs $1.33M and you'll make $65K (profit) from it yearly, then you can compute cap rates

cap rate A = 50000/1000000 = .050
cap rate B = 65000/1330000 = .049

to see that A is a more efficient investment from the point of view of income vs. amount-of-money-you-have-stuck-in-this-investment-and-unavailable-for-use-elsewhere.


Profit margin, on the other hand, cares more about your ongoing expenses than about your total investment. If it costs less to maintain property B than it does to maintain property A, then you could have something like:

profit margin A = (75000 revenue - 10000 upkeep - 15000 taxes) / 75000
                = 50000 / 75000 = .667
profit margin B = (85000 revenue - 3000 upkeep - 17000 taxes) / 85000
                = 65000 / 85000 = .765

So B is a more efficient investment from the point of view of the fraction of your revenue you actually get to keep each year.


Certainly you could think of the property's value as an opportunity cost and factor that into the net profit margin equation to get a more robust estimate of exactly how efficient your investment is. You can keep piling more factors into the equation until you've accounted for every possible facet of your investment. This is what accountants and economists spend their days doing. :-)

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