What Is Cap Rate?
Capitalization rate (cap rate) is one of the most widely used metrics in real estate investing. It measures the annual return on a property as if you paid all cash, removing the variable of financing from the analysis. This makes it ideal for comparing properties across different markets, price points, and financing scenarios.
The Cap Rate Formula
Cap Rate = Net Operating Income (NOI) / Property Value (or Purchase Price)
Expressed as a percentage. If a property produces $18,000 in NOI and is valued at $300,000:
Cap Rate = $18,000 / $300,000 = 0.06 = 6%
Step-by-Step Calculation
Step 1: Calculate Gross Rental Income
Total annual rent at full occupancy. If the property rents for $2,000/month, gross income is $24,000/year.
Step 2: Subtract Vacancy Allowance
Budget 5% to 8% for vacancy. $24,000 x 5% = $1,200. Effective income = $22,800.
Step 3: Subtract Operating Expenses
Include property taxes, insurance, management, maintenance, reserves, and any landlord-paid utilities. Do NOT include the mortgage payment.
Example expenses: $4,800 (taxes) + $1,800 (insurance) + $2,280 (management at 10%) + $1,200 (maintenance) + $1,200 (reserves) = $11,280.
Step 4: Calculate NOI
NOI = $22,800 – $11,280 = $11,520
Step 5: Divide by Property Value
Cap Rate = $11,520 / $250,000 = 4.6%
What Is a Good Cap Rate?
Cap rates vary significantly by market and property type:
3% to 5%: Typical for high-demand, low-risk markets (major metros, coastal cities). These properties offer stability and appreciation potential but lower cash returns.
5% to 7%: The sweet spot for many investors. Balanced risk and return. Common in suburban markets and secondary cities.
7% to 10%: Higher cap rates in more affordable or higher-risk markets. These properties produce stronger cash flow but may carry higher vacancy risk, lower appreciation, or deferred maintenance.
Above 10%: Often signals either a high-risk area, distressed property, or a below-market purchase. Investigate carefully before relying on advertised cap rates this high.
What Cap Rate Does NOT Tell You
Cap rate has important limitations:
- It ignores financing. A property with a 6% cap rate can have very different cash flow depending on the loan terms.
- It does not account for appreciation or depreciation tax benefits.
- It assumes stable income and expenses. If rents are below market or expenses are understated, the actual cap rate differs from the listed one.
- It is a snapshot metric. It reflects current income and value, not future potential.
Using Cap Rate to Compare Properties
Cap rate is most useful for apples-to-apples comparison:
Property A: $250,000 value, $15,000 NOI = 6.0% cap rate
Property B: $400,000 value, $22,000 NOI = 5.5% cap rate
Property A produces a higher return per dollar invested (before financing). An investor prioritizing cash flow might prefer Property A, while an investor in a higher-appreciation market might accept Property B’s lower cap rate for long-term equity growth.
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