What Is a Cap Rate?
The capitalization rate, or cap rate, is a fundamental metric in commercial and residential real estate investing. It measures the rate of return on a property based solely on the income it generates, assuming an all-cash purchase with no mortgage. This makes it a pure measure of a property's income-producing potential, independent of how it is financed.
The formula is simple: Cap Rate = Net Operating Income (NOI) ÷ Property Value. For example, a property generating $30,000 in NOI and worth $500,000 has a cap rate of 6%.
What Is Net Operating Income (NOI)?
NOI is the annual income a property generates after operating expenses but before mortgage payments and income taxes. It equals gross rental income minus vacancy allowance minus operating expenses such as property management, insurance, taxes, maintenance, and utilities paid by the landlord. It does not include mortgage interest or depreciation.
- NOI = Gross rental income − Vacancy & credit loss − Operating expenses
- Include: property management, insurance, property taxes, maintenance, utilities, HOA fees
- Exclude: mortgage payments, income tax, depreciation, capital expenditures
Using Cap Rate to Value a Property
The cap rate can be used in reverse to estimate what a property should be worth given market expectations. If investors in a market expect a 6% return on similar assets, and your property generates $40,000 in NOI, the implied value is $40,000 ÷ 0.06 = $666,667. This approach is the income capitalization method — a standard valuation technique used by commercial real estate appraisers.
- Implied Property Value = NOI ÷ Cap Rate
- If NOI rises (e.g., from rent increases), property value increases proportionally.
- If market cap rates compress (investors accept lower returns), values rise even without NOI growth.
Frequently Asked Questions
What is a good cap rate?
A "good" cap rate depends on the asset class, location, and market conditions. In major gateway cities, cap rates for well-leased assets can be 3–4%. In secondary markets or higher-risk asset classes, cap rates of 6–9% or more are common. A higher cap rate means a higher return but also typically higher risk. Investors should compare cap rates against similar properties in the same market rather than using an absolute benchmark.
Is a higher or lower cap rate better?
It depends on your perspective. A higher cap rate means more income relative to price — better for buyers seeking current income. A lower cap rate means the property is priced at a premium relative to its income, which typically reflects lower perceived risk, better location, or stronger growth expectations. Sellers generally prefer to sell into low-cap-rate (high-value) markets.
How does cap rate differ from cash-on-cash return?
Cap rate assumes all-cash purchase and ignores financing. Cash-on-cash return measures the income return relative to the actual equity invested, taking into account mortgage payments. If you finance the purchase, your cash-on-cash return will be different — sometimes higher (positive leverage) or lower (negative leverage) than the cap rate depending on your mortgage rate.
