# What is a cap rate and how do you use it?

Real estate investors use different criteria to determine whether an investment is right for them. A common valuation method used across is the industry is cap rate, a simple tool to estimate the profit generating power of an investment property.

### What is cap rate?

The capitalization rate, more commonly referred to as cap rate, is a simple percentage that expresses the potential return an investor can expect on their real estate investment. This rate of return is based on the income that the property is expected to generate, taking into account operating costs. The cap rate is calculated by taking the investmentâ€™s net operating income (NOI) and dividing it by the current market value of the property or purchase price, expressed as a percentage:

Net Operating Income (NOI) / Current Market Value = Capitalization Rate

For example, if you are looking at a property that is priced at \$500,000 based off of current market value and after operating expenses you expect the property to generate NOI of \$50,000 a year, the capitalization rate would be 10% (\$50,000 / \$500,000 = 0.10 = 10% ). While expenses such as property taxes and maintenance are included in the NOI, this number does not account for items like depreciation or capital improvements. It is also good to keep in mind that even though a higher cap rate suggests a higher profit annually from the property, like most investments with higher yields, it also implies greater risk.

### What are the main components of cap rates?

There are three components to a cap rate: net income, property value and rate of return, which is essentially the cap rate. By using the simple formula, if two of the components are known, just like any mathematical equation, then the third can be determined. For example, if a property is advertised as having a 5% cap rate and the property value is \$600,000, the calculated NOI is \$30,000. The net operating income (NOI) takes into account all of the revenue of the property minus operating expenses. Operating expenses include any expense needed in order to run and maintain the property such as insurance, property management fees, utilities, property taxes and repairs. But an investor needs to keep in mind that this component does not account for principal and interest payments on the loan, depreciation, amortization or capital expenditures. In addition, investors need to critically examine the financial statements and supporting information to determine whether the NOI provided is actual or projected, and the financial assumptions underpinning it.

### Why is the cap rate important?

The cap rate is an important tool that enables an investor to quickly size up an investment, relative to similar investment opportunities, to identify which ones might meet their financial goals.

### Do hard money lenders focus on cap rates?

When we underwrite a transaction we focus on the final value of the property. If a borrower intends to purchase, renovate, and retain a property for the long-term then the cap rate is an important measure of the value of the property when the renovation is complete and the building is fully leased.