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Cap Rate, short for Capitalization Rate, is a formula used to help determine the value of rental property.  Investors will use the cap rate of a property to help determine a good or bad deal, since it is based on market values (recent sales of similar properties) in the area.

Cap Rate is determined by dividing the net operating income (NOI) by the sale price (SP).  The result will give you a percentage, which is your cap rate.  For instance, a duplex in buffalo bringing in $450 per month per side has a gross operating income of $10,800.  After taxes and some minor repairs, it is determined that the NOI is $9,000.  The property is listed at $65,000, but having a shrewd real estate agent, the final sale price is $60,000.  Using our sample figures, we come to a Cap Rate of 15%.

To determine a cap rate prior to a sale, have your real estate agent pull recent sales figures for similar properties within the last few months.  This will also help you and your agent determine the amount you want to offer for the property.

Determining a good cap rate is influenced by a few factors.  First and foremost will be the local market.  Real estate is localized, so a good cap rate in Buffalo may not be good in Miami.  Sometimes, you may find a difference in cap rates from one area of the city to another!

In addition, buyers and sellers want to see differences in cap rates.  A buyer is looking for a higher cap rate, because that means they are getting more net income out of a property for less of an investment.

Sellers are interested in a lower cap rate, because they want to receive more value for their property.  However, too low of a cap rate may cause a property to sit on the market for an extended period, so the seller is working on a slippery slope between fast sale and best sale price.

Cap rate is not the only thing that needs to be considered in the purchase of an investment property!  Investors must be careful to evaluate each property purchase based on itself as well, considering factors such as structural soundness and operitability of the mechanicals (electrical, plumbing, etc).