Understanding Cap Rates

Every now and then I receive an email from a subscriber asking me to explain "cap rates."

When you are considering real estate for an investment, you take the emotion out of the equation and look at your acquisition from a business perspective. The return on the investment is more important than how the property looks or its location. An important point to consider is the Capitalization Rate, often referred to as the cap rate.

The cap is calculated by dividing the property's annual net operating income (NOI) by its fair-market value. The NOI is determined by taking the effective gross income, and subtracting operating expenses. For example, you purchase a property for $250,000 that rents for a total of $2,000 a month with $20 additional monthly income and $667 in monthly expenses (that's $8,004 annually). Your cap rate is 6.0 percent (which actually would be a marginal return here in the Midwest, but this is just an example).

All things being equal, the higher the capitalization rate, the better the investment!