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What Is a Cap Rate?

Owning real estate can be a lucrative venture. But as with any investment, you’ll have to be prepared to tolerate a certain amount of risk. If you’re planning to buy a property for the sole purpose of renting it out, figuring out the cap rate can help you gauge what kind of return you’ll see on your investment. Here’s a rundown of what the cap rate is, how to calculate it and why it matters.

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Cap Rate Definition

Cap rate is short for capitalization rate and simply put, it’s a way to measure a real estate investment’s profitability. You can estimate the cap rate for both commercial and residential investment properties to get a ballpark idea of the rate of return you’re looking at.

Calculating the Cap Rate

What Is a Cap Rate?

The cap rate is expressed as a percentage and there’s a specific formula you can use to calculate it. First, you’ll need to figure out the property’s net operating income (NOI). This is all the revenue a property generates over the course of a year minus the total amount of money required to maintain it.

If the property you’ve got your eye on is already being rented out, you can look at the total rental cost for the past year. If it’s vacant, you’ll have to look at comparable properties to get a sense of what kind of income it stands to generate.

From there, you can add up all of the expenses associated with managing the property. That would include things that you’re responsible for paying, such as insurance, property management fees, property taxes and maintenance fees.

Once you’ve calculated the NOI, you’ll need to divide that number by the property’s sale price and multiply it by 100 to get the cap rate. For example, let’s say you’re considering a property that’s priced at $350,000 and the NOI comes to $25,000 a year. The cap rate in that scenario would be just over 7%, which is the amount of profit you could reasonably expect to see from year to year.

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Why the Cap Rate Is Important

Investors should be concerned with a property’s cap rate for a few different reasons. For one, it can help you narrow the field when making real estate investment decisions. If you’re comparing two or three prospective properties, for example, calculating the cap rate can give you a sense of which one has the potential to be the most profitable.

The cap rate can also tell you if a property is overpriced and whether its revenue is keeping pace with the market as a whole. Looking at the historical cap rate for the property can give you a sense of how it has performed over time relative to other properties.

Running the numbers on the cap rate can help you exclude properties that don’t fit your investment criteria. If you’ve established a baseline rate of return that you’re not willing to go below, doing the cap rate calculations can immediately tell you if a prospective property makes the cut.

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Finally, the cap rate can help you estimate how long it will take you to recover your initial investment. This is helpful to know if you’re focused on recouping the money as quickly as possible. To calculate the payback period, you’d divide 100 by the cap rate. With a property whose cap rate is 10%, for example, you’d be looking at a 10-year payback period. Higher cap rates are better for investors.

Be Aware of the Limitations

What Is a Cap Rate?

The cap rate is intended to be a snapshot of sorts for a specific property at a specific point in time. But it’s not very helpful for comparing properties held for a short period of time. That’s because the cap rate measures a property’s profitability on a yearly basis.

Bottom line: The cap rate is just one of several factors you’ll need to keep in mind when evaluating a real estate investment opportunity.

Photo credit: ©iStock.com/dem10, ©iStock.com/GlobalStock, ©iStock.com/g-stockstudio

Rebecca Lake Rebecca Lake has been writing about the nuts and bolts of personal finance for nearly a decade. She is an expert in investing, retirement and home buying topics. Her work has been featured on The Huffington Post, Business Insider, CBS News, U.S. News & World Report and Investopedia. As a homeschooling mom of two, she's always looking for ways to make the most of every dollar.
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