Cap rate

[Shai Buki]

Can someone explain me the whole concept of cap rate ? Thanks

[Cruize L.]

Hey @Ayodeji Kuponiyi! 

From what I'm understanding through reading around on the forums, the cap rate is just there to help you figure out whether or not you're getting a good deal compared to the market value of other comparable houses (comps).

If many 2 bd 1b houses in your market are selling at a cap rate of 8% and you're buying a similar house that calculates out to a 9% cap rate then you would seem like you might be getting a good deal. After that you can take a closer look the numbers and make yourself confident in your purchase if the numbers look right. 

To find the market cap rate, find comps and divide the gross incomes (estimated incoming rent) by the total purchase price of the houses. Average those numbers.

Do the same thing for the property you're looking at. 

For an example: 

House R is a 3bd 2b for $250,000 and it will rent out for $1700 a month.

$1700 x 12 (Gross income is the yearly total of rent) = $20,400

$20,400 / $250,000 = 0.0816

That's a cap rate of 8.16%!

But say that the other comps in the area had cap rates of 10+%, then the property you're looking at would clearly be overpriced. 

Cash flow is how much money you will be profiting each month after all the cap ex (cap x = capital expenditures aka utilities, insurance, taxes, property management, etc) are taken out from the rent a tenant pays you. They aren't really related in this case, because if the cap rate for the property you're looking at is lower than the cap rate of comps, you won't be getting as good of a cash flow in your market as you could be.

I tried to explain this as clearly and thoroughly as I could, because I was just as confused when it came to what cap rates were and how to implement them while investing. Maybe someone like me will stumble upon this one day and understand a bit more.

Hope this helps,

Cruize