What Is Cap Rate?

Cap rate is the number real estate investors talk about more than any other. It tells you what kind of return a property generates on its own, without any financing clouding the picture. If you are buying rental property and you do not know how to calculate cap rate, you are guessing.

How to Calculate Cap Rate

Cap Rate = Net Operating Income ÷ Property Value × 100

First you need the net operating income (NOI). That is all rental income minus all operating expenses. Operating expenses include property taxes, insurance, maintenance, property management fees, and vacancies. It does NOT include mortgage payments.

Example: A property generates $48,000 in annual gross rent. Operating expenses total $16,000. NOI is $32,000. The property is worth $400,000.

Cap rate: $32,000 ÷ $400,000 = 0.08 = 8%

That means if you bought the property with all cash (no mortgage), you would earn an 8% annual return on your investment.

What a Good Cap Rate Looks Like

Cap rates vary dramatically by market, property type, and risk level:

• 3-5%: Low cap rate. Typical in premium markets like San Francisco, New York, Seattle. These properties appreciate well but generate thin cash flow.
• 5-8%: Mid-range. Most solid residential rental investments land here. Good balance of cash flow and appreciation.
• 8-12%: High cap rate. Found in smaller markets, C-class neighborhoods, or properties with higher risk. Strong cash flow but potentially less appreciation or more management headaches.
• Over 12%: Very high. Signals potential problems. Could be a war zone neighborhood, deferred maintenance, or unreliable tenants. High return comes with high risk.

There is no universal "good" cap rate. It depends on what you are optimizing for. Cash flow investors want higher cap rates. Appreciation investors accept lower cap rates. Both strategies work.

Cap Rate vs. Other Metrics

Cap rate vs. GRM. Gross Rent Multiplier uses gross rent and ignores expenses. Cap rate uses NOI, which includes expenses. Cap rate is more accurate but requires more data to calculate.

Cap rate vs. cash-on-cash return. Cap rate ignores financing. Cash-on-cash return factors in your mortgage payment, down payment, and actual cash invested. Two investors can buy the same property and have the same cap rate but very different cash-on-cash returns based on their financing.

Cap rate vs. ROI. ROI is broader and can include appreciation, principal paydown, and tax benefits. Cap rate only measures operational return.

Real Example: Evaluating a 6-Unit Building

You are looking at a 6-unit apartment building listed at $520,000.

Gross rental income: 6 units × $1,100/month = $79,200/year
Less vacancy (5%): -$3,960
Effective gross income: $75,240

Operating expenses:
Property taxes: $8,200
Insurance: $3,600
Maintenance and repairs: $6,000
Property management (0% if self-managed): $0
Utilities (common areas): $2,400
Total expenses: $20,200

NOI: $75,240 - $20,200 = $55,040

Cap rate: $55,040 ÷ $520,000 = 10.58%

That is a strong cap rate. Worth digging into. But ask yourself why it is that high. Is it a great deal? Or is the neighborhood rough, the building old, or the seller hiding deferred maintenance? High cap rates always deserve extra scrutiny.

How Sellers Inflate Cap Rates

Watch out for these tricks:

Using projected rent instead of actual rent. The listing says "potential rent of $1,300/unit" but current tenants are paying $1,000. Always use actual collected rent, not projections.

Understating expenses. Some sellers conveniently leave out management fees, capital reserves, or realistic maintenance costs. Calculate your own expenses based on market standards.

Ignoring vacancy. A 100% occupancy rate is not realistic. Use at least a 5% vacancy rate in your calculations, even if the property is currently full.

Excluding capital expenditures. The roof needs replacing in 3 years. The HVAC units are 18 years old. These capital expenditures are coming whether the seller mentions them or not. Factor them in.

Common Mistakes With Cap Rate

Comparing cap rates across different markets. A 5% cap rate in Denver and a 5% cap rate in Detroit are not equivalent investments. Market fundamentals, appreciation potential, and risk profiles are completely different.

Using cap rate for properties you are financing. Cap rate assumes all-cash purchase. If you are putting 25% down and financing the rest, your actual return is better measured by cash-on-cash return.

Ignoring the trend. If cap rates in your market are compressing (going down), that means property values are rising faster than rents. Good for existing owners, tough for new buyers. Watch the trend, not just the number.

Frequently Asked Questions

What is a good cap rate for rental property?

5-8% is solid for residential rental property. Higher cap rates mean more cash flow but often more risk. Lower cap rates are typical in premium markets with strong appreciation.

How do you calculate cap rate?

Cap Rate = Net Operating Income ÷ Property Value × 100. NOI is gross rent minus operating expenses (excluding mortgage payments).

Does cap rate include mortgage payments?

No. Cap rate measures the property's return independent of financing. This makes it useful for comparing properties regardless of how they are financed. Use DSCR to factor in debt.