Cap rate, short for capitalization rate, is one of the most commonly used metrics in real estate investing. It gives you a quick way to estimate the return a property generates relative to its value, without factoring in how it's financed. Understanding cap rate helps you compare investment properties on equal footing and make faster decisions when evaluating deals.
The Cap Rate Formula
Cap rate is calculated by dividing a property's Net Operating Income (NOI) by its current market value or purchase price.
Cap Rate = NOI / Property Value
For example: if a property generates $18,000 in NOI per year and is priced at $300,000, the cap rate is 6%.
$18,000 / $300,000 = 0.06 = 6%
You can also rearrange the formula to estimate value. If you know the NOI and the going cap rate in a market, you can back-calculate what a property should be worth.
Property Value = NOI / Cap Rate
What NOI Includes
Net Operating Income is the income a property generates after operating expenses, but before debt service (mortgage payments) and income taxes.
NOI = Gross Rental Income - Vacancy - Operating Expenses
Operating expenses typically include:
- Property taxes
- Insurance
- Property management fees
- Repairs and routine maintenance
- Utilities paid by the owner
- HOA fees (if applicable)
NOI does not include mortgage principal or interest. That's intentional: cap rate is meant to evaluate the property itself, independent of how it's financed.
What Is a "Good" Cap Rate?
There's no universal answer. Cap rates vary significantly based on:
- Location: High-demand urban markets (major cities, coastal metros) tend to have lower cap rates (3-5%) because buyers accept lower returns in exchange for stability and appreciation potential. Secondary and tertiary markets often see cap rates of 6-10%+.
- Asset class: Single-family rentals, multifamily, retail, office, and industrial properties all trade at different cap rates because their risk profiles differ.
- Property condition and age: Older properties or those in rougher condition often command higher cap rates to compensate for additional risk.
A lower cap rate generally means a less risky, more in-demand property. A higher cap rate means more income relative to price, but typically with more risk attached.
Using Cap Rate to Compare Properties
Cap rate shines when you're comparing multiple properties. Because it strips out financing, you're comparing the underlying economics of each deal on equal terms.
For example, if you're looking at two properties in the same submarket:
- Property A: $500,000 price, $30,000 NOI = 6% cap rate
- Property B: $450,000 price, $22,500 NOI = 5% cap rate
Property A produces more income relative to its cost. Whether that difference is justified depends on condition, tenant quality, and other factors, but cap rate surfaces the gap immediately.
Cap rate is also useful for tracking market trends over time. If cap rates in a given market are compressing (falling), it means prices are rising faster than rents, which signals increasing demand or speculative pressure.
What Cap Rate Doesn't Tell You
Cap rate is a useful starting point, not a complete picture. Here's what it leaves out:
Financing: Two investors buying the same property at the same cap rate can have very different actual returns if one uses all cash and the other uses leverage. Leverage amplifies both gains and losses.
Appreciation: Cap rate is a snapshot of current income. It says nothing about whether the property will be worth more or less in the future. A 5% cap rate in a high-growth market may be a better long-term investment than a 9% cap rate in a stagnant one.
Tax benefits: Depreciation, mortgage interest deductions, and other tax advantages affect after-tax returns but don't appear in cap rate calculations.
Equity paydown: As a mortgage is paid down over time, investor equity increases. Cap rate ignores this entirely.
Cap Rate vs. Other Metrics
Use cap rate for:
- Quick comparisons between properties
- Estimating a property's value based on income
- Evaluating commercial or multifamily deals where financing varies between buyers
Use cash-on-cash return when you want to understand the return on your actual cash invested, taking financing into account.
Use IRR (internal rate of return) for long-term hold analysis that factors in appreciation and sale proceeds.
Calculate Cap Rate Online
To skip the manual math, use the Cap Rate Calculator. Enter the property's gross income, vacancy rate, operating expenses, and purchase price to get the cap rate instantly. You can also use it to estimate property value from a known NOI and target cap rate.