| Line item | Amount |
|---|---|
| Effective gross income (after vacancy) | 90,000 dollars |
| Operating expenses | 40,000 dollars |
| Net operating income (NOI) | 50,000 dollars |
| Property value or price | 1,000,000 dollars |
| Cap rate (NOI / value) | 5.0 percent |
Glossary · Investment
Capitalization Rate (Cap Rate)
The capitalization rate, or cap rate, is a property's annual net operating income divided by its current market value or purchase price, shown as a percent. It estimates the unleveraged annual return an income property produces at a given price, letting investors compare deals of different sizes on equal footing and judge whether an asking price is reasonable.
Also known as: Cap Rate
How is cap rate calculated?
Cap rate equals net operating income divided by property value, expressed as a percent. Divide the property's annual NOI, which is income after operating expenses but before mortgage payments, by the purchase price or current market value, then multiply by 100.
You can rearrange the formula to solve for other figures. If you know the cap rate and NOI, value equals NOI divided by the cap rate. If you know value and cap rate, expected NOI equals value times the cap rate.
Always use annual NOI, not gross rent, and subtract a realistic vacancy allowance first. Because cap rate excludes the mortgage, the result reflects the property, not your specific financing.
What is a good cap rate?
A good cap rate depends on the market, property type, and risk. As a rough rule of thumb, many stabilized rentals trade between roughly 4 and 10 percent. Higher cap rates signal more return but often more risk; lower cap rates suggest pricier, steadier assets.
Prime properties in strong metros often carry cap rates near 4 to 5 percent because buyers accept lower yields for stability and growth. Older buildings or weaker markets may show 8 percent or more to compensate for added risk.
There is no universal target, and a cap rate alone does not make a deal good or bad. Compare it against similar recent sales in the same area. This is general education, not investment advice.
What is the difference between cap rate and cash-on-cash return?
Cap rate measures a property's unleveraged return using NOI and value, ignoring any mortgage. Cash-on-cash return measures the return on the actual cash you invest, factoring in financing and debt service. Cap rate compares properties; cash-on-cash compares how well your invested dollars perform.
Use cap rate to size up a property regardless of who buys it or how. Two investors buying the same building at the same price get the same cap rate but very different cash-on-cash returns depending on their down payment and loan terms.
Because cap rate ignores debt, it can flatter or understate what a leveraged buyer actually earns. Pair it with cash-on-cash return and cash flow for a fuller picture before committing.
Worked example. For example, imagine a small apartment building listed at 1,000,000 dollars. It collects 90,000 dollars in effective gross income after vacancy, and operating expenses such as taxes, insurance, management, and maintenance total 40,000 dollars. Net operating income is 90,000 minus 40,000, or 50,000 dollars. Dividing 50,000 by the 1,000,000 price gives a cap rate of 0.05, or 5 percent. If the same NOI came with an 800,000 dollar price, the cap rate would rise to 6.25 percent.
Common mistakes with Capitalization Rate
- Do not include the mortgage payment in the calculation; cap rate is an unleveraged metric that excludes debt service entirely.
- Do not use gross rent in place of NOI, and always subtract operating expenses and a vacancy allowance first.
- Avoid comparing cap rates across different markets or property types as if they were interchangeable, since risk profiles differ widely.
- Do not treat a high cap rate as automatically better, because it often signals higher risk, older assets, or weaker locations.
- Do not rely on a seller's pro forma NOI; verify actual income and expenses before trusting the resulting cap rate.
Related terms
Term
Net Operating Income (NOI)
A property's income after operating expenses but before mortgage payments and income taxes
Define TermCash Flow
The money left over from a rental property after all expenses, including the mortgage, are
Define TermGross Rent Multiplier (GRM)
A property's price divided by its gross annual rental income, used as a quick screening ra
Define TermCash-on-Cash Return
The annual pre-tax cash flow of an investment divided by the actual cash invested.
DefineCapitalization Rate FAQ
Is a higher or lower cap rate better?
It depends on your goals. A higher cap rate means more income relative to price but usually more risk, while a lower cap rate suggests a safer, pricier asset with steadier demand. Neither is universally better; match the cap rate to your risk tolerance.
Does cap rate include the mortgage?
No. Cap rate uses net operating income, which is calculated before any mortgage principal or interest. It deliberately ignores financing so the metric reflects the property itself, letting you compare buildings independent of how each buyer funds the purchase.
What is the difference between cap rate and ROI?
Cap rate is a specific, unleveraged yield equal to NOI divided by value in a single year. ROI is a broader profitability measure that can include cash flow, appreciation, financing, and equity buildup. Cap rate is one narrow input; ROI captures overall return.
Can you calculate cap rate on a home you live in?
Not meaningfully. Cap rate applies to income-producing property because it needs net operating income from rent. A primary residence generates no rental income, so there is no NOI to divide by value. You would first need market rent estimates and expenses.
How do I find a property's market value from cap rate?
Rearrange the formula: value equals net operating income divided by the cap rate. For instance, 60,000 dollars of NOI at a 6 percent market cap rate implies a value near 1,000,000 dollars. Appraisers and investors use this to price income properties.
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