What Is A "Cap Rate"?

The "cap rate" or capitalization rate of a property is what I call an an "investment measure."  It is a value that compares the income generated with the acquisition cost of an investment. 

For example, if you purchase an investment property for $160,000 and it generates a net income of $16,000, then the cap rate for the property is 10%. 

To take it a bit further, let's look at this example of a Beacon Hill townhome as an investment property:

Purchase Price:  $160,700

Gross Operating Income:  $10,476
($900/month - 3% vacancy)

Operating Expenses:  $1,479
($949 taxes + $405 insurance + $125 POA dues)

Net Operating Income:  $8,997
($10,476 gross operating income - $1,479 operating expenses)

Capitalization Rate:  5.6%
($8,997 net operating income / $160,700 purchase price)

A few other notes about cap rates:

• The cap rate is independent of financing.  It is not a measure of whether an investment property is a "good opportunity" when your particular financing scenario is included.
• Your analysis of operating expenses sometimes would also include management costs, repairs, utilities and advertising
• The cap rate of a particular property can be helpful, but even more helpful is comparing the cap rate of several properties that you might purchase.