In the investment world of real estate, a property is worth the income it generates for its owner. It' not worth its assessed value, its not worth its replacement cost, its not worth what the property next door sold for. Its worth the return on investment in provides.

Each investment property has a different income, and therefore a different value. The idea of the Cap Rate lets us compare the income generating ability of different properties with a simple number.

The Cap Rate is the rate of return that an investor would receive on an annual basis. It assumes the investor pays cash for the property (VALUE) , and reflects the annual net operating income (NOI), which is the gross income less expenses. The Cap Rate is expresses as a percentage.

The formula is CAP = NOI / VALUE.

Another way of thinking of it is the CAP rate is the percentage of the price paid that is returned to the investor annually. It's like the interest rate for a savings account or CD. So conversely, the VALUE of a property to a particular investor can be determined if we know the income it generates (NOI), and the investor's desired rate of return (CAP).

VALUE = NOI / CAP

This shows how we can compare different properties based on the net income they produce, and find the value of a property at an investor's desired rate of return.

Evaluating a real estate investment is not nearly this simple, but this is where we start when looking for property. It makes it easy to decide if a property is worth considering, or if its time to move on to the next one.

Once we find a property that is a possibility, we then evaluate it in terms of the individual buyers financial situation and find its Rate of Return to the particular investor, and see if it makes sense for them. To do this, we need to know

1. the amount of cash available for investment, 2. the minimum down payment or debt coverage ratio required by the lender 3. the marginal or effective income tax rate 4. actual rents and operating conditions of the property (income and expenses) 5. whether the property will be professionally managed or owner managed. 6. What changes will be needed to the property.

Now we can figure the Cash on Cash return, and project the Internal Rate of Return of a property over the time it will be owned.