Cap Rate is a measure of the ratio between the cash flow produced by a property and its capital cost (the original price paid to own the asset) or alternatively its current market value.
The rate is calculated in a simple fashion as follows:
annual cash flow / cost (or value) = Cap Rate
For example, if a building is purchased for $1,000,000 and it produces $100,000 in positive net cash flow during one year, then:
$100,000 / $1,000,000 = 0.10 or 10%
The properties Cap Rate is ten percent.
NOTE: Positive net cash flow = The amount left over after all fixed costs and variable costs are subtracted from gross lease income, however before debt service is subtracted.
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It is important in the fact that it allows you to look at each property in a simialr fashion. However you must be certain that the Net Operating Income is calculated accurately.
What the cap rate represents is merely the projected return for one year if the property were bought with all cash. Not many buy property for all cash, so you have to break the deal down, usually by trial and error, to find the cash on cash return on the actual investment using leverage (debt service).
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A good cap rate can be determined by your market cap rate, as well as your personal preferences on risk allowance vs return.
Josh
