The cap rate is a vital but often misunderstood key to successful real estate investing. When evaluating an opportunity, your first question is likely: What is the cap rate? To use it wisely, however, it’s important to know what the capitalization rate actually means and where it adds value.

The cap rate, short for capitalization rate, measures the ratio between the first year’s net operating income and the property’s purchase price. The ratio is expressed as a percentage and involves three variables: value, interest rate percentage, and net operating income. For example, if you purchase a property for $1 million at a 9 cap, you can expect to make $90,000 in net operating income within the first 12 months. This investment measure tells you what percentage of your cash purchase you can expect to earn back in the first year.

The lower your capitalization rate percentage, the lower your net operating income return will be in the first year. As interest rates decline, it is not uncommon to see rates go down, but when interest rates go up, rates will follow.

Advantages

What is the cap rate best used for? Investors apply this common investment measure as an initial screening to quickly evaluate, on an all-cash basis, whether a property is worth a closer look. You can also use it to further characterize marketed properties. For example, if you know only the rate and the sale price, you can determine the net operating income. You can also plan your exit value with a terminal cap rate.

Pitfalls

Cap rates are only as valuable as their accuracy, and you should be aware of the shortcomings of this approach. Unfortunately, many property marketers miscalculate rates and inflate the investment potential. Many inaccurate cap rates, for instance, result from a faulty net operating income figure. Also, it cannot tell you some information vital to evaluating an investment opportunity. This common investment measure won’t reveal performance after the first year or whether people are willing to pay your rate. It also doesn’t take into account your taxes, debt, and transaction costs. Above all, the widespread errors in advertised figures make it difficult to discern which are accurate.

Your best defense is to know your target cap rate, which is a number unique to your investment situation based on your own debt and cash on cash return assumptions. Well-established formulas can help you determine the right investment measure independent of market trends. By owning the calculation process, you can more accurately value properties and set appropriate exit calculations.

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