What's a Cap Rate?

Get it?? Cap...Rate!

You see it in the Wall Street Journal, commercial real estate marketing materials, generally any type of income producing real estate lingo.  But what the heck IS it?

In it's simplest explanation, a cap rate (short for capitalization rate) is a ratio that real estate professionals use to summarize a deal transaction.  According to Wikipedia, it is "the ratio between the annual net operating income and its capital cost (the original price paid to buy the asset) or alternatively its current market value."  So for example, you want to buy a building for $1,000,000 sales price and it generates $100,000 in net annual operating income:

$100,000/$1,000,000 = .10 or 10% cap rate (to sound smart, just say "at a 10 cap" =P)

*Note that cap rates can only be used for positive cash flowing properties

Investors use this ratio as a form of valuation or indirect measure of how fast an investment will pay for itself.  It will also be used to roughly compare property values.  For example, if a real estate investment provides $100,000 a year in NOI and similar properties have sold based on 8% cap rates, the property can roughly be valued at $1,250,000 because $100,000 divided by 8% equals $1,250,000.  (I know, brush off those algebra skills...).