What is a Cap Rate?

The concept of a cap rate (or capitalization rate) is an important one to understand if you’re a real estate investor. Essentially, a cap rate measures the return on investment, or yield, that is expected from an income-producing property. Understanding the cap rate of a property can be a key factor in evaluating a potential investment, as it gives investors a straightforward, metrics-based way to easily compare the potential returns of competing properties.

Formula for Calculating the Cap Rate

The simple formula for calculating the cap rate is Net Operating Income (annual) divided by Current Market Value. This gives the cap rate as a percentage. Dividing the market value of a property by the net operating income will yield the amount of years required for the investor to receive their money back, or the payback period. The shorter the payback period, the more attractive the investment.

Interpreting Cap Rates

Cap rates vary depending on the type and location of the investment, and can also be influenced by economic conditions and market conditions. Generally, the higher the cap rate, the more attractive the investment. The relative level of the cap rate is also important when evaluating an investment. In other words, if there are higher cap rates available on similar properties in the same area, it’s reasonable to assume that the investor can secure a higher return with the alternative investment.

In conclusion, a cap rate is a key metric to consider when evaluating a potential real estate investment. It’s a straightforward calculation and interpretation of the potential yield of a property, which allows investors to compare different potential investments and make informed decisions on their investments.