Cap rate is a very popular gauge for evaluating the relative value of a property. Quite simply it is the relationship of the price to the income expressed as a percentage. Cap rate= NOI/Price. NOI does NOT include debt. So treat the net income as if you paid cash for the property. Cap rate only looks at 1 year and not multiple years of cash flows.
A much better measure of how a property is going to perform is IRR (internal rate of return). IRR takes into account all expenses, including debt, and all income flows for as many years as you wish to project. It is far more difficult to calculate but a much more complete picture. Something that has a good cap rate may have a lously IRR and therefore be a poor investment.
The most telling calculation as to the relative value of different investments is capital accumulation. It takes into account everything IRR does but tells you what you really want to know and that is, how much money will I accumulate if I hold a property for X amount of time?
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Paul Sylvester, CCIM
Mar 26, 2009