What Is Cap Rate?
Capitalization rate — or cap rate — is the ratio of a property's net operating income (NOI) to its current market value or purchase price. It tells you, at a glance, the unlevered yield a property would produce if you bought it outright with cash.
Formula:
Cap Rate = Annual NOI / Property Price × 100
For example, if a rental property generates $18,000 in annual NOI and you purchase it for $250,000, the cap rate is 7.2%.
Why Cap Rate Matters
Cap rate is the great equalizer. Because it strips out financing, it lets you compare properties of different sizes, in different markets, purchased with different loan structures. A fourplex in Cleveland and a duplex in Phoenix can be compared on the same playing field.
It's also the metric commercial appraisers use most often. When a bank orders an appraisal on a multifamily property, the appraiser will almost always include an income approach that backs into value from the cap rate.
What Counts as a "Good" Cap Rate?
There is no universal answer — it depends on the market, the asset class, and your risk tolerance.
| Market Type | Typical Cap Rate Range |
|---|---|
| Class A / Urban Core | 3% – 5% |
| Class B / Suburban | 5% – 7% |
| Class C / Value-Add | 7% – 10% |
| Rural / High-Risk | 10%+ |
Lower cap rates generally indicate lower risk and higher-priced markets. Higher cap rates signal higher potential yield but often come with more management headaches, deferred maintenance, or volatile tenant bases.
How to Calculate NOI
NOI is the foundation of the cap rate formula, so getting it right is critical.
NOI = Gross Rental Income − Vacancy − Operating Expenses
Operating expenses include:
- Property taxes
- Insurance
- Maintenance and repairs
- Property management fees
- Utilities (if owner-paid)
- HOA fees
- Capital expenditure reserves
Operating expenses do not include mortgage payments, income taxes, or depreciation. Those are financing and tax decisions, not operating costs.
Common Cap Rate Mistakes
1. Using listed rent instead of actual rent. Always base your NOI on what the property is actually collecting, not what the listing agent says it could collect.
2. Ignoring vacancy. Even in hot markets, you should underwrite at least 5% vacancy. In softer markets, 8–10% is safer.
3. Forgetting CapEx reserves. A property that hasn't had a major expense in five years isn't a low-expense property — it's a property that's due for one. Budget 5–10% of gross rent for capital expenditures.
4. Comparing cap rates across different markets without context. A 4% cap rate in San Francisco is not worse than a 9% cap rate in rural Ohio. They represent different risk profiles, appreciation potential, and tenant quality.
Cap Rate vs. Cash-on-Cash Return
These two metrics are often confused. The key difference:
- Cap rate measures the property's yield independent of financing
- Cash-on-cash return measures your actual return on the cash you invested, including leverage
If you buy a property at a 7% cap rate and finance 75% of it at 6.5% interest, your cash-on-cash return will be higher than 7% because of positive leverage. But if rates rise above the cap rate, leverage works against you.
Both metrics matter. Use cap rate to evaluate the property. Use cash-on-cash return to evaluate the deal.
Using Cap Rate to Estimate Property Value
Cap rate works in reverse too. If you know a market trades at a 6% cap rate and a property generates $24,000 in NOI, you can estimate its value:
Value = NOI / Cap Rate = $24,000 / 0.06 = $400,000
This is called the income approach to valuation and it's how most commercial real estate is priced.
Try It Yourself
Use our Rental Property Calculator to calculate cap rate, NOI, and cash-on-cash return for any deal you're analyzing. Adjust inputs in real-time and see how different purchase prices, rents, and expenses affect your cap rate.