What's a cap rate? It's the first concept that separates a homeowner from an investor. It's a simple but handy way to distill the investment potential of a property. It's also incredibly imperfect.

Simply put, the capitalization rate is the annual income potential of an investment as a percentage of the cost.

How to calculate a cap rate.

First, calculate the gross operating income. In residential real estate, that's pretty much just the rent, although other income from parking fees and laundry machines would count. In our example, let's assume the property has three rental units that go for \$1,250 in monthly rent. \$1,250 x 3 units x 12 months = \$45,000 in gross operating income for the three-family home.

Now, let's offset that with the basic operating expenses such as taxes, landlord-paid utilities, and insurance. Don't include mortgage payments (principal or interest) or any other cost that would be specific to you. For our example, the mandatory operating expenses are \$8,000 per year.

This means that our net operating income (NOI) is \$37,000 (\$45,000 - \$8,000).

To get the cap rate, we divide the NOI by the purchase price of the property. If the three-unit building in our example sells for \$800,000, then our cap rate is 4.265%.

How to use the cap rate.

That cap rate percentage allows us to quickly compare investment opportunities against each other. If we found another property with a potential 7% cap rate, it would most likely be the better investment.

What's considered a good cap rate varies wildly by location. In fact, low cap rates can discourage investment altogether in an area.

How not to use the cap rate.

Notice that this simple formula (NOI ÷ Price) leaves out a lot of other factors. The cap rate calculation completely ignores market trends, tenant quality, and the condition of the property. For that reason, cap rates are only good for a quick comparison of properties. Once a investment piques your interest, then take the time for a closer analysis with projected maintenance costs, capital expenditures, and expected appreciation. Don't buy real estate based on the cap rate alone.