The cap rate is one of my favorite tools when it comes to investment properties.  

What is the cap rate?
The cap (Capitalization) rate is the rate of return provided, prior to financing, by the cash flow of an investment property.

The equation to determine the cap rate of a property looks like this:

Cap Rate = Net Operating Income from the property / Fair Market Value of the property

Let me give you a simple example.

You purchase a property for $500,000 and the property’s net operating income (income after operating expenses but before any interest, principle or depreciation) is $50,000.  

Your cap rate is 10% ($50,000 / $500,000).

What Can the Cap Rate of a Property Tell You?

#1 – A cap rate can tell you how leverage (debt) will affect your investment.  
If the cap rate of a property is higher than the borrowing cost (interest rate), it is an indicator that the property’s cash flow will cover the interest cost.

If the cap rate is less than the interest rate, it is an indicator that the property’s cash flow will not cover the interest cost.  

#2 – A cap rate can provide indicators as to when to sell or buy.
If cap rates are trending downwards, it may be time to sell. A downward trend is an indicator that property values are increasing.

If cap rates are trending upwards, it may be time to buy.  An upward trend is an indicator that property values are decreasing.

Using Cap Rates in Your Wealth Strategy
Cap rates provide a quick snapshot to help alert you that you may need to do some deeper analyzing and take action.  Cap Rates are even more powerful when you track the trends.

Of course, cap rates are only one tool when it comes to analyzing investment property and anytime you buy or sell an investment property, it should be part of your overall wealth strategy.