When you first you first start to analyze deals and look for a property to invest you will start to see and hear a term called Cap Rate. In this post I am going to try to answer a few question about Cap Rate and help to clarify it for you.
What is Cap Rate and How to Determine the Cap Rate?
Cap Rate (Capitalization Rate) is the ratio of your NOI (net operating income) to the property value. A simple example would be a property sold for $100,000 and the NOI was $10,000 then the cap rate would be $100,000/$10,000 or 10%.
Well you might be thinking how do I know what my NOI (net operating income) is? Here is how you figure that out.
Potential Rental Income
- Vaccancy
____________________________
=Effective Rental Income
+ Other income
____________________________
=Gross Operating Income
- Operating Expenses
___________________________
Net Operating Income (NOI)
Note:
What is included in Operating Expenses:
Management
Legal and accounting
insurance
Maintenance
taxes
utilities, etc.
Why is it important?
In the most simplest terms it is a quick way to determine your return on your investment. It gives you a quick snap shot or overview of the value of the deal. The nice thing about Cap Rate is that is the most commonly used baseline for comparing investment properties. With that said, I advise everyone to preform their own analysis on a property they are thinking about purchasing and don't just take the sellers or brokers word for it or the cap rate that they provided.
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