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Cap rates are used to evaluate the potential worth or value of an investment deal.

To figure out a properties cap rate take the annual projected income and subtract expenses. This results in the net operating income (NOI). Divide the net operating cost by the properties price or value and then multiply by 100.

For example on a rental property take the expected amount of income you expect you earn and then subtract any expenses that will be acquired. Then divide the result (NOI) by the property price and multiply by 100. You will end up with a number that can be used to compare the rental investment to other property investments. The higher the number (Cap Rate) the better the potential worth or value of the property.

To figure out the cap rate:

(NOI / price of building ) x 100 = Cap Rate

Let’s take another example, suppose you want invest in a new business premises and you need to figure out if it is a good deal or not. One of the things you could do to find out would be to find out what the cap rate of similar properties in the area is. Let’s say you check with a local realtor and discover that the cap rate of similar business premises in the area is 5. So the lowest cap rate you would want to pay is 5, remember the higher the better.

You research the building some more and find out that it has a net operating income (NOI) of $150,000. Given that you already know the desired cap rate is 5 you can now calculate the price you would be willing to pay.

Figuring out target price using a desired cap rate:

(NOI / desired cap rate) x 100 = The price you would be willing to pay

(150,000 / 5 ) x 100 = 3,000,000.

So the highest price you would be willing to pay if you wanted to have a cap rate of no less than 5 would be $3,000,000.

You can also use this method to compare investments such as stocks, bonds, or savings deposit accounts. Cap rates allow for a simple numerical comparison of investments that can be hard to compare using other means.