For those new to real estate investing and for the others who are considering the possibility, you will soon run into terms that you may not be familiar with. All industries have their own jargon, some of which may be familiar and some that’s outright foreign. But one term you may have heard before butinvesting in real estate not clearly understood is the “cap rate.”

The cap rate, short for “capitalization rate” is a shortcut method to evaluate a potential investment. The cap rate can be used for single family rentals to multi-unit apartment buildings. But cap rates need to be understood and placed in context before they can be properly used.

A cap rate is expressed as a ratio or a percentage. A property’s cap rate is determined by dividing the annual net operating income with the purchase price. For instance, say there is a four unit property and each unit rents for $2,000. After expenses, including mortgage interest, taxes and the like are deducted from gross revenue, the net operating income falls to $1,500 per unit, or $72,000. If the property sold for $500,000 then the cap rate is $72,000 divided by $500,000 = .14, or simply 14. Is that a good number? It can be if similar cap rates for four unit properties have a lower cap rate. All things being equal the property with the higher cap rate provides a better net return.

But cap rates tell you when a prospective property warrants a bit more research. It’s important to know the nature of the real estate market in the area. How are market rents? Are the expenses of the properties with a lower cap rate out of line and can the cap rate be improved? Cap rates are best applied when comparing like properties in the immediate area. A cap rate for an apartment building in downtown Dallas compared to a single family rental in St. Louis is meaningless. Finding cap rates is relatively easy to do, just make sure they’re used properly.