To calculate cap rate, divide a property's net operating income by its value or purchase price, then multiply by 100. If a rental nets $24,000 a year and is worth $300,000, the cap rate is $24,000 / $300,000 x 100, or 8%. The cap rate is a quick way to compare income properties on the same basis, because it ignores how each one is financed. You can get the figure instantly from the cap rate calculator, and this guide shows how to build it, what counts as income and expenses, and what a "good" cap rate looks like.
What is a cap rate?
The capitalization rate, or cap rate, is a property's annual net operating income expressed as a percentage of its value. It answers a simple question: if you bought this property in cash, what annual return would the income produce? A higher cap rate means more income per dollar of value, which usually signals a higher return and higher risk. A lower cap rate signals a more expensive, often safer, asset.
Cap rate deliberately ignores financing. Two investors can buy the same building with very different loans, but the property's cap rate is the same for both. That is what makes it useful for comparing deals.
How do you calculate cap rate?
The formula has two inputs: net operating income (NOI) and value.
- Calculate gross income. Add up the annual rent and any other income, such as parking or laundry.
- Subtract operating expenses to get NOI.
- Divide NOI by the property value and multiply by 100.
In formula form: cap rate = (NOI / property value) x 100. The hard part is not the division; it is getting NOI right.
What counts as net operating income?
NOI is your gross income minus operating expenses. The expenses that belong in NOI include:
- Property taxes
- Insurance
- Property management fees
- Repairs and maintenance
- Utilities you pay as the owner
- A vacancy and credit-loss allowance
Three things are deliberately excluded from NOI: your mortgage payment, capital improvements (like a new roof), and depreciation. Leaving out the mortgage is what keeps cap rate independent of financing. The most common way cap rate gets inflated is by understating expenses, especially vacancy and maintenance, so be realistic.
Worked example
Suppose a rental brings in $36,000 a year, costs $12,000 a year to operate, and is valued at $300,000.
- Net operating income: $36,000 minus $12,000 = $24,000
- Cap rate: $24,000 / $300,000 = 0.08
- As a percentage: 0.08 x 100 = 8%
The property has an 8% cap rate. For comparison, the gross yield (rent before expenses, divided by value) is $36,000 / $300,000 = 12%, which is why cap rate, not gross yield, is the figure investors compare. The cap rate calculator returns the cap rate, NOI, and gross yield together.
What is a good cap rate?
There is no universal "good" cap rate, because it reflects both return and risk. As a rough guide:
| Cap rate | Typical setting |
|---|---|
| 3% to 4% | Prime, low-risk markets; expensive coastal cities |
| 5% to 7% | Stable, average markets |
| 8% to 10% | Cheaper or higher-risk areas; more management |
| 10%+ | High risk, problem properties, or rough neighborhoods |
A low cap rate is not automatically bad, and a high one is not automatically good. A 4% cap rate in a city with strong rent growth can beat a 9% cap rate in a declining area. Cap rates also move with interest rates: when borrowing costs rise, cap rates tend to rise too, as data from the Federal Reserve Bank of St. Louis on rates and commercial real estate shows. Industry bodies like Nareit publish cap-rate trends across property sectors, which is a useful benchmark for your market.
How do you use cap rate to value a property?
The formula rearranges to estimate value. Property value = NOI / cap rate. If a property nets $24,000 a year and similar properties in the area trade at an 8% cap rate, an estimated value is $24,000 / 0.08 = $300,000. Investors use this constantly: find the going cap rate for comparable buildings, then apply it to a property's NOI to judge whether the asking price is fair.
Cap rate vs cash-on-cash return vs ROI
Cap rate is one of several return measures, and they answer different questions. Mixing them up leads to bad comparisons, so it helps to know what each one captures.
Cap rate measures the property's return as if you paid cash, using net operating income over value. It ignores financing entirely, which is exactly what makes it good for comparing buildings.
Cash-on-cash return measures the cash income you keep after the mortgage, divided by the actual cash you invested (down payment plus closing costs). Because it includes the loan, it changes with your financing. Two buyers of the same property can have very different cash-on-cash returns.
Total return on investment (ROI) is broader still. It folds in cash flow, loan paydown, tax effects, and any appreciation over your holding period. It is the most complete measure but also the hardest to estimate, since it depends on assumptions about the future.
A quick way to remember the difference: cap rate judges the property, cash-on-cash judges your deal, and ROI judges the whole investment over time. Use cap rate first to compare candidates on equal footing, then run cash-on-cash on the front-runners once you know your loan terms. Leaning on cap rate alone can make a heavily financed property look better or worse than it really is for your situation.
What cap rate does not tell you
Cap rate is a snapshot, not the whole picture. It leaves out several things:
- Financing. Two buyers with different loans see very different cash returns. Cash-on-cash return captures that.
- Appreciation. Cap rate measures income only, not future value gains.
- Growth. A low cap rate can be justified by strong expected rent growth.
- Your costs of capital. A mortgage payment can turn a healthy NOI into thin cash flow.
That is why serious investors pair cap rate with other measures. Once you have settled on a property, the mortgage recast calculator helps you plan the loan, and the prorated rent calculator handles partial-month rent when tenants move in or out.
Putting it together
Cap rate is income divided by value, expressed as a percentage. Get NOI right by counting all operating expenses and a vacancy allowance, then divide by the price. Compare the result to similar properties in the same market rather than a fixed target, and remember it ignores your loan.
The most common mistake is an inflated NOI from optimistic expenses. Use real numbers for taxes, insurance, management, and maintenance, and always include a vacancy allowance, even on a property that is currently fully rented. A cap rate built on honest expenses is a far better guide than a high number built on wishful thinking. Run your figures through the cap rate calculator to get the cap rate, NOI, and gross yield in one step.