What's a Good CAP Rate to Buy Real Estate? Learning the jargon is the first step to knowing what you're getting into investing in real estate.

By Grant Cardone

Opinions expressed by Entrepreneur contributors are their own.

Jupiterimages | Getty Images

Are you scared to have your money in the stock market (like I am) but also tired of almost no return on investment with your money at the bank? Do you really like the idea of being invested in income producing real estate with results you can actually see? If so, you will need to learn the terms of real estate, and one of the most important terms you need to understand is CAP rate, which stands for Capitalization Rate. It's how investment properties are measured.

As a real estate investor that many people look to for advice, the number one question I get asked is, "What CAP rate do you buy?" but this is the wrong question. One piece of data doesn't substantiate a deal. CAP rate is important but don't get locked into focusing just on one term. All the pieces of data matter.

With that caveat, to understand a CAP rate you simply take the building's annual net operating income divided by purchase price. For example, if an investment property costs $1 million dollars and it generates $75,000 of NOI (net operating income) a year, then it's a 7.5 percent CAP rate.

Usually different CAP rates represent different levels of risk. Low CAP rates imply lower risk, higher CAP rates imply higher risk. The question is, what is the right CAP given the riskiness of the deal?

Related: 4 Ways to Kick-Start Your Career in Real-Estate Investment

When looking at CAP rates and what the right CAP rate should be for a property, you need to look at several things:

Location

To say that location is everything might be an overstatement -- but I don't believe it is. Location matters because a location is what drives demand.

Is the property in Manhattan or rural West Virginia? A larger, wealthier,and better-educated population will drive a local economy more, this is why CAP rates are lower in a place like LA than in Memphis. This is why even within large metropolitan areas CAP rates can be significantly different from each other, with properties near downtown usually having lower CAP rates (and risk) than properties in the suburbs. But again, there are no strict rules to follow, every location has its perceived risk.

Related: 8 Ways Real Estate Is Your Smartest Investment

Interest rates

If the Fed adjusts rates, that can fluctuate CAP rates up to 1 percent, even with no changes to the property itself. If you are a real estate investor, rising interest rates will mean a fall in property values. When interest rates rise the cost of debt rises and that decreases your net cash flow. This is why even though you don't have much direct control over interest rates, you need to be aware of what they are and what direction they might be headed.

Related: 3 Tech Trends Helping to Bring New Investors to Real Estate

Asset class.

You can buy many different types of property: office, industrial, retail, hotel…but I only do one type of asset --multifamily. This has the lowest perceived risk, so it usually has the lowest CAP rates. People will always need a place to live, no matter the economy. The boutique hipster café will come and go, but that 64 units next door will be there even when the economy tanks.

Remember -- the lower the CAP rate, the higher I can sell it. What's a good CAP rate? It depends. I would have made a fortune in San Diego 20 years ago buying extremely low CAP rate properties. Think about the whole deal, like how you will exit, not just the current CAP rate.

There is one number more important than the CAP rate: 1.25

That's the Debt Coverage Ratio you want. Look at this before you look at the CAP rate. You want the NOI bigger than the debt—a minimum 25% more income than debt. I prefer 1.50 for properties I take on.

For more on real estate, be sure to subscribe to my Real Estate Show every Monday at noon EST.

Wavy Line
Grant Cardone

International Sales Expert & $1.78B Real Estate Fund Manager

Grant Cardone is an internationally-renowned speaker on sales, leadership, real-estate investing, entrepreneurship and finance whose five privately held companies have annual revenues exceeding $300 million.

Editor's Pick

She's Been Coding Since Age 7 and Presented Her Life-Saving App to Tim Cook Last Year. Now 17, She's on Track to Solve Even Bigger Problems.
Lock
I Helped Grow 4 Unicorns Over 10 Years That Generated $18 Billion in Online Revenues. Here's What I've Learned.
Lock
Want to Break Bad Habits and Supercharge Your Business? Use This Technique.
Lock
Don't Have Any Clients But Need Customer Testimonials? Follow These 3 Tricks To Boost Your Rep.
Why Are Some Wines More Expensive Than Others? A Top Winemaker Gives a Full-Bodied Explanation.

Related Topics

Business News

California Woman Arrested For $60 Million Postal Service Scam

Lijuan "Angela" Chen faces two charges that each carry a maximum sentence of five years in prison.

Growing a Business

Trendspotting 101 — How to Stay Ahead of the Curve in Your Industry

Learn how to spot and capitalize on emerging trends in your industry with these practical tips.

Business News

A Wegmans Employee Allegedly Stole Over $500,000 from the Company

Alicia Torres pleaded guilty to crimes carried out over nine years while working at Wegmans in Webster, New York.

Business News

Hundreds of People Mistakenly Told They Have Cancer in Biotech Software Mishap

The biotechnology company, Grail, said a software issue caused one of its vendors to accidentally send nearly 400 letters mistakenly telling patients they have cancer.

Growing a Business

How to Harness the Power of Data Analytics for Business Growth

To thrive in the competitive landscape, entrepreneurs must understand and leverage the power of data analytics.