Another ratio that’s used frequently in analyzing a rental property is the capitalization rate, or “cap rate”.
Put simply, the cap rate is the Net Operating Income divided by the purchase price. NOI/Price. It’s very similar to the yield on a bond. How much do I have to pay to buy the asset, and how much return do I get on it?. Or, even more simply, it's like interest you get on your savings account. Except real estate's returns aren't guaranteed. And you hopefully earn more than what the banks pay on savings accounts and CDs.
Cap Rate = NOI / Price
This is helpful when you want to compare the returns of different properties. Is 8% a good cap rate? Depends on the market. In Montpelier, you’re not going to get an 8% rate. You’re going to get something much lower. In markets such as San Francisco and Boston, investors might be buying at a 1%-2% cap rate, because they’re banking on appreciation to goose their return.
Again...it’s like a bond. The risk free, US government backed T-bill is going to pay a lower interest rate than a riskier B-rated bond (or a junk bond).
Knowing what “average” cap rates are in a market are helpful, because they give you a quick and easy way of evaluating an investment.
Perhaps even more interestingly...from algebra class, we can reconfigure this as:
Price = NOI / Cap Rate
Now we’re getting somewhere. If I can figure out the NOI of a building, and I have an idea as to what typical cap rates are in my area, then I can land at an evaluation for the property. I might be able to find a good deal, and I might be able to know that it’s a good deal.
At Green Light Real Estate, we’ve been calculating NOI and cap rates for multi-family properties in Barre, Montpelier, and Northfield for years. We’re always happy to help new and experienced investors!