What is a Cap Rate?

Not so sure how to answer the above question? Here’s what you need to know:

A capitalization rate, or a cap rate as it’s often referred, is the rate of return anticipated for one year if the property was paid for in cash — It’s the ratio between Net Operating Income (NOI) and the property value.

If you pay $1 million on a property in cash with a 10 percent cap rate, for example, you should expect to see $100,000 rate of return per year.

For investors or brokers, you’ll have to calculate your Net Operating Income (NOI) to identify the cap rate. To do that, you’ll need to account for the Gross Scheduled Income (GSI) of potential renters and subtract the vacancy rates and property expenses to calculate your gross income. The net profit you generate before debt, divided by the purchase price of the property, is your cap rate.

Now, it’s not often that investors are buying properties in cash. Frequently, they’re incurring debt and placing a certain percentage down on the property.

If you’re intending to leverage the property, you’ll want to subtract total yearly debt costs, or your annual debt service, from your calculated NOI to identify net cash flow. Most often, your cash-on-cash return should be slightly above the cap rate if your borrowed interest rates fall below it.

Let’s say you’re a property owner and you want calculate the cap rate of your own property. First, hop online and look at property comparables. Let’s say you come across a 20-unit apartment building with a NOI of $50,000 and it sells for $1 million. That’s a cap rate of 5 percent. It’s as simple as that.

Remember, cap rates are extracted from the market, so keeping close attention to what’s selling today is crucial in determining the perfect cap rate for your property.

Read more about finding local cap rates. Or use our free service to discover your market’s cap rates!