Ask the expert: What is a cap rate?

You might have heard the term “cap rate” among those who invest or aspire to invest in real estate. Short for “capitalization rate,” the concept is key if you’re going to pursue a career in rentals and/or commercial properties.

The cap rate is a method for estimating the potential return on a property and assumes it’s paid for with cash. The formula includes dividing the Net Operating Income (NOI) by purchase price, or value; NOI is the gross income minus expenses except for debt service.

Example: A property costs $100,000 and generates $10,000 in income. NOI/Value means 10k/100k = 10% cap rate.

Debt service isn’t included because cap rate makes all things equal. The investor who will finance a property knows that it starts at a 10 percent cap rate and then does additional figuring to arrive at his or her actual return on investment (ROI).

So what’s a good cap rate? That’s up to you. Similar to comps in single-family properties, it’s important to know the typical cap rate in your area. So a “10 cap” might be the norm where you’re from, while a “7 cap” is acceptable elsewhere. And every investor has their individual threshold as well.

It gets more complex, naturally. Investors also need to consider things like depreciation and capital expenses, and evaluate whether the NOI is accurate. There are also other ways to calculate your return. But for a quick analysis and a way to help determine optimal purchase price, cap rate is the way to go.