If you decide to get into real estate investing, you will very quickly hear the term “cap rate” be thrown around quite often. The capitalization rate is a concept that you need to understand immediately, if you are going to be able to analyze possible opportunities and determine whether or not they are worth investing in.
Capitalization Rate = Net Operating Income / Purchase Price
The cap rate is a percentage that can be derived from a very simple formula that divides the Net Operating Income (i.e. the yearly profits from all incomes) by the price that you paid for that property.
For example: Let’s say that I bought a house for $100,000. It rents for $12,000 per year. The taxes are $1,200 per year and insurance is $500 per year. The net operating income is derived as follows:
$12,000 (rent) – $1,200 (taxes) – $500 (insurance) = $10,300
The cap rate can then be determined to be:
$10,300 (net operating income) / $100,000 (purchase price) = 10.3%
This is a very simple example. In reality, the net operating income would require you to factor in additional expenses such as property management, maintenance costs, reserves for capital expenditures, etc. I kept it simple for the purposes of understanding the basic concept.
Why Use Cap Rates?
The cap rate is a very important figure to determine when analyzing rental properties. It essentially provides you with the return on your investment. It is the percent of your original investment that will be provided to you in incomes each year.
The cap rate is also a reflection of your current real estate market. It is a gauge of the values that investors are willing to trade properties at. In my market, a 10% cap rate is a great deal but in a smaller, more rural market, a 10% cap rate could mean that you are overpaying for your property. You can use the cap rate as a general litmus test for the stage of any real estate market, and although I do not recommend you use only that as a measure for underwriting your real estate deals, it is a great starting point.