What is Cap Rate? – Real Estate Investing Terms to Know, Part 4

How do you feel about the myriad of real estate definitions out there? Cash Flow, Cash on Cash Return (CCR), and Net Operating Income (NOI) are all “lingo” and “jargon” you hear in the investing community. We’ve been deconstructing these terms and taking them down to the brass tacks, one by one, so you can learn. We sincerely hope that these terms no longer breed confusion but foster understanding instead. You’ll see how each one of these definitions and calculations build upon each other.

(Photo: Franck Blais)

The Capitalization Rate (“Cap Rate”)

The “cap rate”, short for capitalization rate, is simply the percentage of return you’ll get on a property investment. There’s just one little rule here: the property is fully paid for. On a cap rate, you take a look at a property’s return without taking mortgages into account. Remember your Net Operating Income (NOI)? Yep, you’re going to need that now. You’ll also want to get the listing price of the property to run this comparison.

[contentblock id=ar_top_banner_responsive]

Here’s the straightforward equation:

That’s all there is to it! To make things easier, let’s pull in our $100,000 property from the last three Investing Defined blogs and crunch some numbers!

[su_animate type=”rotateIn” duration=”1″][contentblock id=subscribe][/su_animate]

Remember: Your Net Operating Income was found in the previous post.

Monthly Net Operating Income = $549 * 12 months = $6,588
Cost/Value of Property = $100,000

Now, let’s plug it all into the equation…

Cap Rate = $6,588 / $100,000

Okay, so it looks like you have a Cap Rate of about 6.6%. What does that mean to you? Well, compare that to your Cash on Cash Return (CCR) that we came up with last week. Is it higher or lower?

Cap Rate = 5.5%, Cash on Cash Return = 7.14%

Looks like it is lower in this case. In this example, you are getting more return on your investment by borrowing against this property.Whenever the value is higher, it means that you are better off paying the property in full than leaving it leveraged. You always have other factors to consider. How much debt are you willing to get yourself into? What about vacancies and being stuck with a monthly mortgage? These are all concerns within themselves, but data gives you the power to make decisions.

We hope an understanding of Cap Rate will make your borrow vs. pay in full decision easier, and if you have the cash to be able to make that decision, then you’ve done well my friend! Keep reading the blogs and doing that due diligence!

What else can a Cap Rate be used for?

There’s one other particular use we like. Look at the historical cap rate of a particular property over time. You might see something like this:

[table id=2 /]

One conclusion you could make is that property values are being bid up and the market is getting hotter. The cap rates are compressing in the example above–in other words, they are increasing at a slower and slower rate every year. Cap rate compression as it’s called, shows you that there’s a strong demand for income producing properties in that area. Although cap rates are cyclical by nature, a good 5 year snapshot like this can allow you to get a little more insider info on our local market.

Infinite Returns,
Bill

[contentblock id=before_you_leave]