For those that have been thinking about investing in real estate or are just starting out on this lucrative path, it can be a bit intimidating at first. Especially when you begin hearing industry terms bandied about as common phrases and it’s possible that you can end up hearing the term and withoutunderstanding cap rates asking anyone else, you don’t quite understand its meaning.

And because real estate investing has multiple players in any given transaction, each with perhaps its very own set of jargon, it’s understandable to be somewhat bewildered right out of the gate. One term that you will often hear is a term that is used to describe the nature of a particular real estate investment. An income producing property. It’s the “Cap Rate.”

The cap rate comes from the proper term “capitalization rate” and is a number expressed as a percentage, or a ratio and makes the connection between the overall acquisition cost of a property and the income, after expenses, produced over the course of a year. Its’ easily calculated and more easily understood. The cap rate divides the net income by acquisition cost and the higher the cap rate, the better. Let’s look at a couple of calculations for a duplex. The duplex was bought for $250,000 and produces annual income at a $25,000 per year clip. The cap rate is:

$25,000 / $250,000 =  0.10, or 10.

By switching up the numbers a bit and lowering the anticipated net income, we arrive at a different number:

$18,000 / $250,000 =  0.07, or simply 7.

Again, the higher the cap rate, the better the deal but cap rates can only go so far. Different areas will have different prevailing cap rates due to local market conditions and you need to know the intimate details of the market. Cap rates will give you a general description of a projects’ income potential but is only the starting point as more due diligence is needed beyond the cap rate. Yet it is indeed a starting point for all income producing properties and helps investors more quickly identify a potential deal.