Capitalization Rate

Capitalization rate, or cap rate, is net operating income divided by purchase price. It is the return the property pays before any financing, and the unlevered counterpart of cash on cash return. The two start from the same NOI; cap rate divides it by price, cash on cash subtracts debt service and divides by cash invested.

On the default $250,000 deal, $20,105 of NOI is an 8.0% cap rate. Bought for cash, the cash on cash return is about 7.7%, slightly under the cap rate because closing costs and repairs sit in the denominator. Bought with 25% down at 7.25%, it is 6.3%.

The pair defines leverage. When the cap rate is above the mortgage constant, financing lifts cash on cash above the cap rate. When it is below, financing drags it under. Use cap rate to judge whether the property is priced fairly against comparable sales, then cash on cash to judge whether your financing makes it a deal you can hold.

Further reading: Capitalization Rate on Wikipedia.