Cap Rate is used in Commercial and Investment Real Estate to determine the return on investment (ROI) of a given property or portfolio, and can be extremely useful when comparing different investment properties.
Basically speaking, the Cap Rate is expressed as a percentage, and is determined by subtracting the difference between GROSS OPERATING INCOME and OPERATING EXPENSES to arrive at the NET OPERATING INCOME of a given investment.
The NET OPERATING INCOME (NOI) is then divided by the asking or purchase price of a property to come up with a percentage rate, known as the CAP RATE.
Example: Duplex earns $900 per unit per month, plus $350 per year from coin-operated laundry machines. That is a gross operating income of $21,950. The Operating Expenses, including property taxes, rentals of water heaters, water/sewer bills, building insurance, and maintenance costs total $6,223 for the year. That leaves a Net Operating Income of $15,727. If the asking price of this property is $260,000, the CAP RATE at full purchase price would be 6.05%.
Cap Rates fluctuate according to market conditions, and building quality / location.
As a general rule of thumb, the NICER/NEWER the physical building, and the BETTER the location, the LOWER the CAP RATE, as this is a safer investment that requires less upkeep, repairs, and with the good location, ideally reduced tenant turnover. The LESS ATTRACTIVE the physical building, the higher the cap rate, as these buildings generally require more maintenance, and can have higher turnover with tenants.
There are costs that fall outside of this calculation, like the lifetime costs of major systems in a home. We can do a further calculation with more information about a given property, called a CAP-EX, but that exceeds the scope of this definition.