What is the Cap Rate and How do You Take Advantage of It?
What is the Cap Rate?
Many beginners do not know what Cap Rate means. The Cap Rate is just a number indicating the profitability of a property compared to other properties in the vicinity.
Here is how you calculate a Cap Rate: Take the total Net Operating Income (NOI), divide it by the property’s Market Value, and multiply it by one hundred. Let’s break that down.
Net Operating Income (NOI)
You calculate the Net Operating Income or NOI as all the annual income from the property minus all the expenses. So if the income from rent is $100,000, and expenses are $20,000, the Net Operating Income or NOI is $80,000 ($100,000 – $80,000 = $80,000)
The market value is challenging to figure out. Most people will use an appraisal of comparable properties that have sold in the area to develop an approximate market value. If the property is for sale, it is easier to determine the Cap Rate based on the sale price. Let’s imagine that the property is selling for $1 million.
Cap Rate – Putting it All Together
As mentioned above, the Cap Rate takes the total Net Operating Income (NOI), divides it by the Property’s Market Value, and multiples it by one hundred. So in our example, the Net Operating Income or NOI was 80,000, and the market value was $1,000,000
80,000/1,000,000*100 = 8.
So One would say that this deal is an 8 Cap.
Is an 8 Cap good?
Cap rate is only one piece of data to consider. There are other indicators when analyzing real estate deals. The deal’s overall profitability depends on the financing type and interest rate attached to that financing. Location is also an important aspect.
Cap Rate is one data point of many that real estate investors will consider when evaluating a property to purchase as an investment.