A Cap Rate, or Capitalization Rate, is a measure of the return of a particular real estate asset compared to its value and net operating income. Cap Rates are typically used to evaluate the unlevered return of a property when considering an acquisition. They are also commonly used to determine the current value of a property when considering a refinance. The way to determine the cap rate of a property is to divide the net operating income by the value or acquisition price.
For Example
– You are considering purchasing an apartment building with a net operating income of $100,000. You know that market cap rates for this type of property are around 8%, so it should be worth somewhere around $1,250,000 ($100,000/.08). Therefore you now that if you are paying more than $1,250,000, you are overpaying for the property.
Cap Rates are very useful when evaluating expected returns and purchase price of any particular property. However you need to understand how to properly underwrite a properties net underwriting income and be sure that the income and expenses that you use to determine it can be proven out.