Cap Rate (Capitalization Rate)
Cap rate is net operating income (NOI) divided by purchase price. It tells you how much a property earns as a percentage of what you pay for it — before any mortgage enters the picture. A $160,000 property producing $11,548 in NOI has a cap rate of 7.2%.
Cap rate is one of the two or three metrics you should calculate on every rental property before anything else.
Why financing is excluded
Cap rate is intentionally financing-free. Two investors can buy the same property, one with cash and one with a loan, and both face the same operating economics. Cap rate captures that. Once you layer in financing, you get cash-on-cash return — a different, also useful number.
This separation is what makes cap rate useful for comparing properties across markets or deal types, regardless of how you plan to finance them.
The formula
Both inputs matter:
| Input | What it means | Common mistakes |
|---|---|---|
| NOI | Gross rent − vacancy − operating expenses (before debt service) | Using seller's stated NOI without verifying vacancy and expense assumptions |
| Purchase price | The actual price you pay | Using appraised value or list price instead of contract price |
Worked example
A $160,000 single-family rental. Monthly rent is $1,800.
| Line item | Annual amount |
|---|---|
| Gross rent | $21,600 |
| Vacancy allowance (8%) | − $1,728 |
| Property taxes | − $2,600 |
| Insurance | − $1,100 |
| Maintenance | − $1,600 |
| Property management (9%) | − $1,944 |
| Capital reserves (5%) | − $1,080 |
| NOI | $11,548 |
Cap rate = $11,548 ÷ $160,000 × 100 = 7.2%
What the number tells you
Cap rate converts the purchase price and income into a single, comparable percentage. A higher cap rate means more income per dollar paid — but higher cap rates usually come with higher risk or worse locations.
| Cap rate range | What it typically signals |
|---|---|
| Below 4% | Premium market or trophy asset; thin income cushion |
| 4–6% | Core market (major metros, strong demand) |
| 6–8% | Secondary market or value-add play |
| 8–10% | Tertiary market, older stock, or distressed situation |
| Above 10% | Elevated risk or distress; verify every assumption |
These ranges are ballparks. What matters most is whether the cap rate adequately compensates for the specific market, property type, and risk you are accepting.
How cap rate connects to other metrics
Cap rate, NOI, and price form a three-variable equation. If you know any two, you can solve for the third:
| What you know | What you can solve for |
|---|---|
| NOI + purchase price | Cap rate (screening) |
| NOI + target cap rate | Implied value (offered-price check) |
| Target cap rate + purchase price | Required NOI (underwriting minimum) |
Investors use this to work backwards: if comparable properties in the market sell at a 6.5% cap rate and this property's NOI is $11,548, the implied value is $11,548 ÷ 0.065 = $177,662. If the seller is asking $210,000, the deal is priced at a 5.5% cap rate — you need to decide whether that gap is justified.
Common mistakes
1. Using gross rent instead of NOI. Sellers sometimes present "cap rate" using gross income before vacancy and expenses. That number is meaningless. Always verify the NOI inputs.
2. Accepting the seller's vacancy assumption. A seller may show 2% vacancy on a property in a market with an 8% census vacancy rate. Correcting this alone can drop cap rate by 50–100 basis points.
3. Excluding capital reserves. A pro forma without a reserve line (typically 5% of gross rent) will overstate NOI — and therefore overstate cap rate.
4. Comparing across property types without context. A 7% cap rate on a Class A multifamily means something different than a 7% cap rate on a Class C single-family. Class and location matter.
Where it fits in your workflow
Cap rate is a screening tool — use it before modeling the full deal:
- Get the listing income and expense statement
- Recalculate NOI using your own vacancy and expense assumptions
- Divide by asking price
- Compare against local market cap rates for similar properties
- If it looks competitive, proceed to full underwriting (cash flow, DSCR, cash-on-cash return)
If cap rate does not clear your threshold at the asking price, you either negotiate a lower price or move to the next deal.
Frequently asked questions
What is a good cap rate for a rental property? There is no universal answer. A good cap rate depends on your market, property type, and target return. In high-demand metros, investors accept 4–5% because appreciation offsets thinner current income. In smaller markets, most investors want 7–9% to justify the risk. Compare cap rates of recently sold comparable properties in your target market, not national averages.
Does cap rate include the mortgage? No. Cap rate is calculated before debt service. That is intentional — it lets you evaluate property performance independent of how it is financed. To account for financing, use cash-on-cash return.
What happens to cap rate if rent increases? If rent goes up and the purchase price stays the same, cap rate (as calculated from your original underwriting) increases. In practice, if you are evaluating whether to sell, the relevant cap rate uses the current market value, not your original purchase price.
Can I use cap rate for a fix-and-flip? Not directly. Cap rate is for income-producing rental properties. For flips, the primary metrics are after-repair value (ARV), rehab costs, holding costs, and profit margin.
Is a higher cap rate always better? Not necessarily. Cap rate and risk tend to move together. A 10% cap rate in a declining market with high vacancy may be worse than a 5.5% cap rate in a growing market with strong tenant demand. Always evaluate what the cap rate is compensating you for.
Cap rate is an analytical metric, not investment advice. Returns shown are illustrative. Always verify inputs with current market data and consult qualified professionals before making investment decisions.