02: Cap Rate

In last week’s Weekly Wealth Widget, we talked about Net Operating Income (NOI). To summarize, this is basically the net income after all revenues and expenses without a mortgage.

Another critically important term in the language of real estate investing is the capitalization rate or simply “cap rate.”

The cap rate is simply defined by the net operating income divided by the sale price of the property.

Cap rate=NOI/sale price.

Cap rates are used to value real estate assets that are a little bit bigger. We usually don’t talk about cap rates in the context of residential properties with 4 or less units.

However, as you will come to learn, cap rates are critical in the valuation of most real estate property.

Another way to think of the cap rate for a given property is the return on investment (ROI) that is bought without a mortgage. For example, let’s say you paid $100,000 cash for a property and the net operating income on the property was $9000. The return on investment for the property would simply be $9000/$100,000 or 9 percent. Because there is no mortgage, the cap rate is also 9 percent.

One last thing to put this in context. At a given time, any market has a cap rate for a specific asset class. For the most part, cap rate dictates the price of property. This is very different and much more predictable than valuing a single family home or duplex which is far more subjective. We will discuss valuation in further detail next week.