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Cap Rate

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What is Cap Rate?

Cap Rate is short for Capitalization Rate.  It is calculated by dividing the yearly income of the asset by the value of the asset. Cap RateThe higher the cap rate, the more money is being produced with the same amount of money that has been invested.  Dividend yield of a stock is a very similar calculation.  In real estate investing, cap rate is commonly used to compare potential investments.  It can also be used as a way to gauge investments into smaller companies that rely on heavily assets. A few ways to increase the cap rate of an investment property would be to:

  • Use leverage or other people's money.  This may hurt your net income, but it will reduce the amount of money put into your property.
  • Invest into small projects to increase your what you can charge for rent.  Replacing or improving the property in certain ways will help you get more out of your tenants.

How to use it:

For Example, Alice has a rental condo that produces a net income of $3000 a year.  The condo is worth $100,000.  Her cap rate would be 3%. Now, let's say that a train station opened right down the street from this condo.  Her value of her condo increased to $150,000 and she could charge more for her rent and is now bringing in a net income of $3500 a year.  Her cap rate would be 2.3%.  Notice that with an increase of value and an increase in income, does not mean an increase in cap rate.

To spice things up: Alice another property.  She will have a mortgage for this property and has only put down $20,000 for the down payment.  After her mortgage and her expenses are paid, she would receive a net income of just $600 a year.  The condo is still worth $100,000.  Her cap rate, using leverage, would be 3%. After calculating her cap rate and using leverage, she might be able to increase her cap rate overall by selling her condo and using leverage for other properties.

*Please note that 3% cap rate might be good in some markets, or bad in other markets.  Please don't compare these numbers to your own.

Further Reading:

http://www.investopedia.com/terms/c/capitalizationrate.asp

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  1. Pingback: How to Use the 50% Rule - My Financial Wisdom

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