If you're actively investing in real estate, you know that a cap rate is a measure of the rate of return you might expect from an investment property. Simply stated, it is the annual net operating income divided by the market value of the property:
As an example, suppose that you purchased a rental home for $200,000, and that based on a monthly rent of $1500, your annual net income was $15,500 after expenses. Your cap rate would be 7.75%. Note that in figuring cap rates, net operating income is defined as earnings before depreciation and interest expense.
Cap rates can also provide some insight into valuing a property based on its income generation potential:
Cap rates are simple enough, but that's also their limitation. While CAP rates can be easily and quickly generated and are good for quick comparisons between income properties, they have limited utility as a tool for evaluating the real worth of an investment.
If you have found an investment property to which you would like to give some serious consideration, let us know. We have a very useful investment spreadsheet that we'd be happy to share with you. It's easy to use and will give you a much more detailed look at how an investment may perform, based on your input of detailed property and financial data. And while it's a bit more effort than simple division, it will give you the kind of information you need to determine how a potential investment will fit with your criteria and goals.