Cap rate is another investment formula commonly used by investors for evaluating properties. The cap rate is arrived at by dividing the net operating income (which is the gross operating income minus operating expenses) by the value or price paid for the property.
For example, if a real estate investment has a net operating income of $10000 and an approximate value of $100,000 then the cap rate is determined by by dividing $10,000 by $100,000 which equals a 10 per cent cap rate.
Some advantages are it brings operating expenses into the analysis and it is well known due to its wide use in real estate appraisal.
Disadvantages include the following:
Cap rates represent the rate of return on a real estate investment that is owned free and clear and do not factor in debt service on mortgage.
The cap rate does not allow for other relevant factors that include appreciation or depreciation, financial leverage or mortgage amortization, income taxes and risk.
However, it is very useful in quickly developing a percentage rate of return on a real estate investment.