Cap Rate (Capitalization Rate)
A property's net operating income divided by its value or price, shown as a percentage. Cap rate = NOI ÷ value. It expresses the unleveraged annual return and is the core metric for valuing income property.
The capitalization rate — "cap rate" — is the ratio of a property's annual net operating income to its value or purchase price:
Cap Rate = NOI ÷ Property Value
It answers a single question: if I paid all cash, what unleveraged annual yield would this property produce? A property generating $24,000 of NOI that sells for $400,000 trades at a 6% cap rate (24,000 ÷ 400,000).
How investors use cap rate
Cap rate is the lingua franca of income-property valuation. Rearranged, it becomes a pricing tool:
Value = NOI ÷ Cap Rate
If comparable rentals in a submarket trade at a 6% cap and your target produces $30,000 of NOI, the implied value is 30,000 ÷ 0.06 = $500,000. Lenders and appraisers use this same income-capitalization approach to value the collateral behind a DSCR loan, especially on small multifamily.
Reading the number
- Higher cap rate → lower price relative to income, generally higher perceived risk or a softer market (think tertiary cities, older product).
- Lower cap rate → higher price relative to income, typically prime markets and newer assets where investors accept a thinner yield for stability and appreciation.
Cap rates compress when capital is plentiful and expand when financing tightens.
A worked example
| Item | Amount |
|---|---|
| Gross annual rent | $42,000 |
| Operating expenses | $12,000 |
| NOI | $30,000 |
| Purchase price | $500,000 |
| Cap rate | 6.0% |
What cap rate leaves out
Cap rate is unleveraged — it ignores your mortgage entirely. That's a feature: it lets you compare two properties' raw earning power independent of how each is financed. But it means cap rate is not your actual return once you add a loan; for that you use cash-on-cash return. It also ignores appreciation, tax benefits, and capital expenditures. Treat cap rate as the starting point for valuation, not the whole investment thesis.
Frequently asked questions
What is a good cap rate for rental property?
It depends entirely on the market. In prime metros, 4–6% is common; in tertiary or higher-risk markets, 7–9%+ is typical. A 'good' cap rate is one that's competitive for that submarket and asset class while still meeting your return targets — there is no universal threshold.
Does cap rate include the mortgage?
No. Cap rate is an unleveraged measure — NOI divided by value, with no debt service in the math. It deliberately strips out financing so you can compare properties on their raw earning power. To factor in your loan, use cash-on-cash return.
How is cap rate different from cash-on-cash return?
Cap rate divides NOI by the full property value and ignores financing. Cash-on-cash divides your annual pre-tax cash flow (after debt service) by the actual cash you invested. Cap rate measures the asset; cash-on-cash measures your leveraged return.