For a new real estate investor, the term ‘cap rate’ can be intimidating. Fear not! This term is easy to understand and we’ll explain how to use it.
Cap Rate is the Yield of a Property
Do you understand what the interest rate on a bank account or CD means? Do you understand what the dividend yield on a stock is? If so, you already understand what cap rates are. They are the yield (in percentages) or investment return of a property.
Here it is as a formula:
Cap Rate = (All income minus expenses / Property Market Value)
Let’s look at an example. If a property’s value is $100,000 and, for a given year, after all expenses are subtracted from all rental income, there is a net income of $10,000, then the cap rate of that property is 10% ($10,000/$100,000).
How Is This Used?
Investors compare cap rates when evaluating different properties on the market. Generally, higher cap rates are more desirable. However, just as a higher return can be a signal of risk, properties with high cap rates can often be more risky. For example, an investment may have only a single tenant paying all the rent or is located an area with declining economic prospects.
That’s it! Easy Peasy, right?
Now you know what cap rates are, how to calculate them, and how they are used as a comparison tool.
If you are looking to sell a property that you already own, it is important to track your income and expenses so that you can properly calculate your property’s cap rate. There are many tools to do this. RentalIncomeExpense.com is one such free online landlord software tool that tracks rental property income and expenses.