Please explain CAP rates

[Mario J Perez]

I've heard of different formulas to determine CAP rate. Two of them are:
1. NOI/Purchase price
2. (Annual rent/2)/Purchase price.
Assuming expenses are about 1/2 of income. Please explain the difference.
Once I get the CAP rate, what does it tell me?
Thanks,
Mario

[Jon Holdman]

The first formula is the definition of cap rate. In other words, its the return you would see on the property if you paid cash.

An estimate of the NOI is "rent/2". That's just another way of saying the "50% rule".

In descriptions of properties, brokers and seller often understand expenses and make the NOI look higher than it probably really is. That makes the property seem more valuable than it really is. The "50% rule" is simply a screening tool to allow you to see when the seller is jerking your chain. If the seller claims expenses are 30% of the gross scheduled rent, you KNOW they're leaving things out. Or, even worse, they have been deferring maintenance on the property and you have a lurking time bomb.

If you combine the two forumlas:

Cap rate = NOI/price
NOI = rent/2

You get your second forumla

Cap rate = rent/2/price

(Remember your high school algebra? Who said that class was useless?)