What Is Cap Rate?
You’re looking at a $2 million apartment building that generates $150,000 in annual net operating income. The broker says it’s a “7.5% cap rate deal.” What does that actually mean for your investment?
Cap rate (capitalization rate) is the annual return you’d earn
on a property if you bought it entirely with cash.
It’s calculated by dividing the property’s net operating income (NOI) by its purchase price or current market value. Think of it as the property’s yield, similar to how a bond pays interest.
This simple percentage tells you how efficiently a property turns income into value. Higher cap rates typically mean higher returns but also higher risk, while lower cap rates suggest stable, premium properties in prime locations.
The Quick Formula
The cap rate formula is straightforward:
Cap Rate Formula
Cap Rate (%) = (NOI / Property Value) × 100
Example: ($150,000 / $2,000,000) × 100 = 7.5%
What goes into the numbers:
NOI (Net Operating Income): Your total rental income minus operating expenses (property taxes, insurance, maintenance, management fees). This is before mortgage payments.
Property Value: The purchase price or current market value of the property.
Want to see the complete math with step-by-step examples? Check
out our Cap Rate Formula guide
for detailed calculations.
Real-World Examples
Apartment Building
Solid return for a well-maintained building in a good location.
Single Family Rental
Typical for residential rentals in stable markets.
Commercial Property
Higher return but potentially higher risk or older building.
How Investors Actually Use Cap Rate
Cap rate isn’t just a mathematical exercise—it’s a practical tool that investors use every day to make smarter decisions.
1. Quick Property Comparison
When you’re evaluating multiple properties, cap rates let you compare apples to apples. A 6% cap rate on one building versus 8% on another tells you which property generates more income relative to its price, making it easier to identify potentially better deals.
2. Estimating Property Value
If you know a property’s NOI and what cap rate investors expect in that market, you can estimate what the property should be worth. This is exactly what our Property Value Calculator does—it reverses the formula to find value from NOI and cap rate.
3. Evaluating Deals Quickly
When a broker presents a property, the cap rate gives you an instant sense of whether the deal is in the right ballpark. If similar buildings in the area are trading at 7% cap rates and this one is at 5%, you know it might be overpriced (unless there’s something special about it).
4. Market Analysis
Cap rates reveal market trends. Rising cap rates might indicate increasing risk or falling property values, while falling cap rates often signal strong investor demand and rising prices.
Limitations & Common Mistakes
Cap rate is powerful but it’s not the complete picture. Smart investors understand what it misses to avoid costly mistakes.
Remember: Cap rate is just one tool in your toolbox. Never make an investment decision based on cap rate alone.
What Cap Rate Doesn’t Include:
Mortgage payments: Cap rate ignores financing costs. Your actual cash return will be different after loan payments.
Capital expenditures: Major repairs like roof replacement or HVAC systems aren’t reflected in NOI, but they significantly impact your real return.
Future rent growth: Cap rate is a snapshot in time. It doesn’t account for potential rent increases or market appreciation.
Tax implications: Depreciation benefits and tax consequences aren’t captured in the cap rate calculation.
Common Mistakes to Avoid:
Confusing cap rate with ROI: Cap rate is unleveraged (all-cash), while ROI includes financing. Learn the difference.
Ignoring property condition: A high cap rate might look attractive but could signal deferred maintenance or hidden problems.
Not considering location: What’s “good” in one market might be terrible in another. See typical cap rate ranges.
Over-relying on pro forma numbers: Sellers often provide optimistic NOI projections. Always verify actual historical numbers.
Related Tools & Guides
Cap Rate Calculator
Calculate cap rates, NOI, or property value with our free interactive tool.
Cap Rate Formula
See detailed calculations, step-by-step examples, and formula variations.
What Is a Good Cap Rate?
Explore typical cap rate ranges by property type and market.
FAQ
Frequently Asked Questions
What does a 6% cap rate mean?
A 6% cap rate means the property generates annual net operating income equal to 6% of its value. For a $1 million property, that's $60,000 in annual NOI. This is generally considered a moderate return, typical for stable residential properties in good markets.
Is a higher cap rate always better?
Not necessarily. Higher cap rates mean higher returns but usually indicate higher risk, poorer location, older buildings, or less desirable properties. Lower cap rates often suggest premium properties in prime locations with stable income. The 'best' cap rate depends on your investment strategy and risk tolerance.
Does cap rate include mortgage payments?
No. Cap rate is calculated before financing costs—it assumes an all-cash purchase. This makes it useful for comparing properties regardless of how they're financed. If you want to see your actual cash return after loan payments, you need to calculate cash-on-cash return instead.
What's the difference between cap rate and ROI?
Cap rate measures the property's unleveraged return (NOI divided by property value), while ROI (Return on Investment) includes all factors like financing, tax benefits, and appreciation. Cap rate is a snapshot metric for comparing properties, while ROI is more comprehensive but also more complex to calculate.
How do I calculate NOI for cap rate?
NOI = Gross Rental Income - Operating Expenses. Include rent, laundry fees, parking revenue, and other income. Subtract property taxes, insurance, maintenance, management fees, utilities, and other operating costs. Exclude mortgage payments, depreciation, and capital expenditures. For detailed guidance, see our <a href="/noi-cap-rate">guide on NOI and cap rate relationship</a>.