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What is a cap rate in relation to investment property?

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A capitalization rate, or cap rate, in relation to real estate property is a means of calculating the property's value when contemplating purchase for investment, according to About.com. The cap rate is determined by dividing the cost of the property by its expected income minus its expenses, reports Nolo.

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Full Answer

The cap rate determines the income potential of a piece of property by percentage, states Nolo. It helps investors planning to rent property determine whether the net income of the real estate is worth the asking price. The total annual rent income is easy to estimate if the property is already being rented, but if it's not already rented, investors estimate income based on a survey of the rents from similar surrounding properties. Expenses a property typically encounters include property taxes, insurance, utilities that are the landlord's responsibility, the cost of regular repairs and maintenance, and an estimated 5 to 10 percent rent loss due to vacancies.

Real estate with a low cap rate is generally not a good investment, because even minor difficulties such as tenants falling a few months behind on the rent can cause the property to lose money, according to Nolo. Properties with high cap rates generally offer good returns on investments. Properties with cap rates of 4 to 10 percent annually are usually good investments.

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