With the CAP RATE as a tool in your investment toolbox, you’ll be able to more confidently buy and profit from investment properties.
Commercial investors also need to determine their capitalization rate (CAP RATE) and Gross Rent Multiplier (GRM) to decide if an investment is a good decision.
The CAP RATE and GRM are useful calculations when investing. The cap rate formula is Annual Net Operating Income/Purchase Price. Usually, a sound investment has a 6.5-10% cap rate.
For example, if an investment property costs $1 million dollars and it generates $65,000 of NOI (net operating income) a year, then it's a 6.5 percent CAP rate. A higher cap rate means a higher risk investment. A lower cap rate means an investment is less risky. So, proceed with caution. A property with a high cap rate might not be the best investment for you. A large loss to a small investor has a much larger impact than the same amount to a wealthy investor with deep pockets.
( NOI = Rental Income + Other Income – Vacancy Losses – Total Operating Expenses )
The formula used to calculate the GRM is: Purchase Price/Monthly Gross Operating Income.
You should also consider the property comps, appraisal vs. assessment, income, and replacement costs when considering if a deal is worth it.