The Pros and Cons of Using Cap Rate

There are a lot of weird terms within the world of real estate that make it daunting for beginners. In this series of posts, I go through these terms and explain them in an easy to understand way. My hope is that you gain a new understanding of the terms used within the world of investing and use this newfound knowledge to build a steady stream of passive income. The term covered in this post is Cap Rate.

Do you want a quick way to approximate the returns on a real estate investment property? Capitalization rate, or cap rate for short is a good way for investors to compare buy and hold, income generating properties.

The formula for Cap Rate is actually pretty simple. It is

Cap Rate = NOI / Purchase Price

This formula does bring up a second question, what is NOI? I would write a second post on NOI but it is incredibly easy to calculate after you have an understanding of what makes it up. NOI is calculated by taking your annual income minus your annual expenses (without mortgage payments and expenses for Cap Ex). Your NOI should be positive.

By calculating NOI, you will have a better understanding of the income yield. This metric is NOT a set in stone, bulletproof way to guarantee your investment, but it does give you a simple way to compare like investments. Take this as an example. You are looking at two very similar homes in your market. Both homes are in the same condition and need the same amount of repairs. The difference is that one offers a 7.8% Cap Rate and the other offers a 7.2% Cap Rate. You would want to take the home with the higher Cap Rate because it is more likely to offer a higher income yield and thus perform better.

There are two main issues with Cap Rate that needs to be addressed. The first is that it does not take into account financing. The other is that Cap Rates do not include hidden expenses that come along with owning a rental. Sometimes new investors will put too much emphasis on Cap Rates and will fail to understand the entire picture. Oftentimes Cap Rate makes the investment seem a little better than it actually is.

What is a good Cap Rate?

Cap Rates are constantly fluctuating but you should shoot for anywhere between 4% and 7%.

I hope this post helps you and that you continue working towards a life of financial freedom!