How to calculate Cap Rates

When dealing with investment property one will hear the term cap rate often. Cap is an abbreviated version of capitalization, which is a way of determining the rate of return on an investment property. In order to calculate the cap rate one must know the price of the property and the net operating income which creates the following equation:

(to better understand how net operating income is calculated refer to this article: http://greenbayproperty.blogspot.com/2008/05/what-is-real-net-operating-income.html ) ,

Cap rate = NOI / Price of Property or NOI / Cap Rate = Price of Property

To use a simple example lets say an apartment complex sells for $100,000 (cheap I know, this is an example). The NOI on the property is $15,000. If we plug those two numbers into the equation:

15,000 / 100,000 = 15% cap rate

But how do we know if this is a good rate of return? The best way to judge how good the cap rate is, is by reviewing comparable sales' cap rates. If the similar properties have a lower cap rate then the 15% is a higher than average rate and could be considered a deal. Cap rates are also directly affected by interest rates and correllate when they go up or down. Similarly each type of property and each market has cap rates that differ from different property types and markets. It is best to do substantial research into what type of property you're looking to invest and what typical financials are for those that are sold in that particular market and price point.

Cap rates are just one of many ways to analyze a property, but they are a fundamental form of investment analysis and should be done on any investment property to determine if it's worth the asking price.