The Use of Capitalization Rate for Landlords

The capitalization rate, or "cap rate" for short, is basically a mathematical term that tells us how well an investment property is performing.

If we were to write the cap rate formula on a blackboard, it would simply be a property's annual net operating income (NOI) divided by the property's purchase price, taken as a percentage. And in this formula, the annual net operating income is the property's effective gross rental income minus all operating expenses (but before subtracting the mortgage payments).

To look at cap rate from another perspective, if you were to purchase a property with all cash and no mortgage (quite a feat!), the cap rate would then be your cash-on-cash return produced by the property. It would be the property's NOI divided by your 100% purchase price cash investment.

The practical application of Cap Rate

Cap rate has a useful application when comparing two or more investment properties and trying to determine which one to buy.

Example:

With all other factors being equal (property conditions, locations, etc), property #3 has the largest cap rate and is the best investment choice.

For more detailed information on cap rate, please visit The Landlord's Library book collection. It's a great reference source that covers the complete subject of residential landlording, a true one-stop information source for landlords of all sizes and shapes.