What is the true definition of cap rate?

Capitalization rate, or cap rate, is often incorrectly used to determine a property’s, or real estate, value. Many people in the real estate industry (including sellers, lenders, and brokers) set a property’s price by using their method of determining the cap rate: Dividing the net operating income by the sales price.

An example of this is a property’s net operating income is $150,000 usd and the price is $1,150,000 usd. To find the cap rate, according to the common short-cut method of people in the real estate industry and by the majority of people over all:

$150,000/$1,150,000 = 13% capitalization rate

This is usually not a realistic or useful determination of a cap rate because it only considers that the property is paid in cash and this is only a one-year projection. How often do people buy a piece of real estate with cash? Not often. Often do you only need a one year projection and no more? Never. To determine the real cap rate, which is, obviously, more useful you must determine the cash-on-cash return which must add into the factor the amount of debt that will give us this leverage. (To determine this cash-on-cash return using debt leverage is not an easy method as you have to try, try, and try again). The debt is then subtracted from the net operating income and the true return will then be found. If any of the factors change then everything must be recalculated.

Yet this is more effective than the shortcut method of finding the cap rate and it is definitely more useful. It will give you the facts which in turn, will help you make better purchasing and investing real estate decisions.

About Stephane Manos

Stephane Manos has developed several online companies. While working as an online entrepreneur, he fell in love with the sales aspect and recruited some of the best clients and affiliates the companies have ever had. The fun, he found was in building the connections and relationships. One of Stephane's top qualities is being able to motivate. He found a passion in motivating others which in return motivated him. Happy colleagues and clients would send word-of-mouth referrals and increase traffic to his online businesses. Teamwork is something that Stephane promotes. The focus is not on self or individuals but in working as a team to reach the same goals. It is his role as a leader to lead the team by example. Currently, his interest is in real estate investments and financial investments. He is now looking into emerging markets such as the Middle East. He also believes some of the better deals can be found in certain parts of the United States. Many distressed buyers are looking to liquidate. Developing new online businesses, purchasing commercial and residential real estate, and developing rentals has led him to travel around the world. Stephane Manos contributes a portion of his time and earnings to charitable associations and philanthropic groups. His charities are: -Children's Telethon -AHEPA brotherhood and Shriners -REVIVRE Bipolar Support Assocation
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