What is Cap Rate? Explained.

We hear the term "cap rate" thrown about all the time.  What is cap rate or what is the cap rate in your area?  I don't think most Realtors even know what cap rate is, or how it helps someone assess a property.  I think most Realtors just say 10% by default.

Very Basically cap rate is defined as the following

Capitalization Rate = Net Operating Income / Value (Selling price)  

If we assume a 10% cap rate then we should be able to solve for whichever variable we are looking for.  I think most commonly we use the two known variables of Net Operating Income and Value to come up with cap rate.

What if we want to establish a desired cap rate...surely investors don't default to 10%.  So to figure out a desired cap rate you would consider the following three items. 

1.) Return of Investment (how long it will take the investor to to recoup their initial investment)

2.) Return on a low risk or safe investment (bonds, savings account etc)

3.) Return for the added risk on this investment (percent you want to earn per year on your investment)                                                                                                       

So lets put some numbers with this.

1.) You expect it to take 20 years to recoup your investment (1/20)x100= 5%

2.) Lets say for this example you can put your money into a savings bond at 3%

2.) You'd like to earn 5% per year on your investment = 5%

 

Add them all together and you have your desired Cap Rate of 13%

 

Now that you have your desired cap rate you can use that number to solve for either desired NOI or Value.

David Monsour, Realtor with Prudential Bob Yost - Sites Homesale

Buying, Selling, or know someone that is? Call me I'd love to help.

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