What Is Cap Rate?
Cap rate (capitalization rate) is a rental property's net operating income divided by its price or value, shown as a percentage. It is used when comparing income properties or estimating value, and matters because it shows the yield before financing on the same basis for every property.
Cap Rate in plain English
Think of cap rate as the yield a property would pay if you bought it with cash. Take the rent it collects, subtract the costs of running it, and compare what is left to the price.
Because it leaves the mortgage out, cap rate lets you compare a duplex and a small apartment building - or two listings in different towns - on the same footing, whatever loan each buyer uses.
Advanced explanation
Cap rate is NOI divided by value or price - an unlevered, single-year yield measure. In direct capitalization, value = NOI ÷ cap rate, so small cap-rate changes move value substantially. Going-in cap rates use current or forward NOI at purchase; exit (terminal) cap rates estimate value at sale. Cap rate ignores financing, capital expenditures below NOI and income growth.
Formula
Cap Rate = Net Operating Income ÷ Property Value × 100- Net Operating Income
- A year of rent and other income, less vacancy and operating expenses, before mortgage payments.
- Property Value
- The purchase price for a going-in cap rate, or a current value estimate.
Related forms: Property Value = Net Operating Income ÷ Cap Rate; Net Operating Income = Property Value × Cap Rate.
Uses one year of income; it ignores growth, financing and the cost of major replacements.
Worked example
Cap rate on a $400,000 rental
Illustrative example - round numbers, not current market data. Calculated with Reaixo's calculator engines.
Assumptions
- Purchase price
- $400,000
- Market rent
- $3,000 a month
- Vacancy and credit loss
- 5%
- Operating expenses (taxes, insurance, repairs, management)
- $10,200 a year
| Step | Calculation | Result |
|---|---|---|
| 1. Gross potential rent | $3,000 × 12 | $36,000 |
| 2. Less vacancy | $36,000 × 5% | $1,800 |
| 3. Effective gross income | $36,000 − $1,800 | $34,200 |
| 4. Net operating income | $34,200 − $10,200 | $24,000 |
| 5. Cap rate | $24,000 ÷ $400,000 × 100 | 6.00% |
Cap rate: 6.00%. Before any mortgage, the property earns 6.00% of its price a year from operations. A buyer who paid $450,000 for the same income would earn only 5.33%.
What this calculation leaves out
- Mortgage payments are not in NOI, so cap rate says nothing about cash flow after financing.
- Capital expenditures such as a new roof are usually shown below NOI; a property with a large backlog can look better than it is.
- The result is only as good as the rent, vacancy and expense estimates. Use actual operating statements when you can.
Try it: Cap Rate with your own numbers
Interactive and illustrative: change any value and the results update instantly in your browser. The figures come from the same engines as REAIXO's full calculators.
Cap rate matrix: NOI against value
Cap rate starts from NOI - income after vacancy and operating expenses - never from gross rent. The matrix shows how the rate moves when NOI or the value changes.
- Net operating income
- $24,000
- Effective gross income $34,200
- Cap rate
- 6.00%
- NOI ÷ value
- Gross yield (not the cap rate)
- 9.00%
- Rent ÷ value ignores expenses
| NOI \ Value | $360,000 | $380,000 | $400,000 | $420,000 | $440,000 |
|---|---|---|---|---|---|
| $21,600 | 6.00% | 5.68% | 5.40% | 5.14% | 4.91% |
| $24,000 (yours) | 6.67% | 6.32% | 6.00% ◀ | 5.71% | 5.45% |
| $26,400 | 7.33% | 6.95% | 6.60% | 6.29% | 6.00% |
Formula
NOI = Gross income × (1 − Vacancy %) − Operating expensesCap rate = NOI ÷ Property value × 100Assumptions
- Operating expenses exclude the mortgage, depreciation and capital improvements.
- Cap rate ignores financing; compare it only with properties of a similar type and location.
Why it matters
Investors use cap rate to quickly compare income-producing properties on an apples-to-apples basis, independent of how each is financed.
Cap rate turns income into value. At a 6% cap rate, every $1,000 of extra annual NOI supports about $16,700 of value; raising rent or cutting costs therefore moves the price far more than the dollar change suggests.
Paying a price that implies a lower cap rate than similar properties means accepting less income per dollar invested, or betting on growth.
What it means for you
How does it affect an investment?
Cap rate sets the starting yield. If your loan costs more than the cap rate, borrowing lowers your cash return (negative leverage); if it costs less, borrowing raises it.
What professionals should verify
Confirm which NOI the cap rate uses - trailing 12 months, in-place or pro forma - and whether reserves are deducted. Two analysts can report different cap rates on the same property.
Common mistakes
- Using the seller's pro forma rent instead of actual collected rent.
- Leaving out vacancy, management or repairs, which inflates NOI and the cap rate.
- Comparing cap rates across very different property types or markets as if they were the same.
- Treating cap rate as total return - it excludes appreciation, loan paydown and tax effects.
Cap Rate vs. Cash-on-Cash Return
Property-level operating return before financing — NOI divided by property value. Useful for comparing properties independent of how they're financed.
Return relative to the actual cash invested — the down payment, closing costs, and upfront renovation spend — after accounting for financing.
Full comparison: Cap Rate vs Cash-on-Cash Return, with a worked example →
Gross Rent Multiplier vs. Cap Rate
Price divided by gross annual rent, before any expenses — a fast screening number that ignores operating costs entirely.
Net operating income divided by property value, after operating expenses — a more complete (but slower to calculate) return measure.
GRM is useful for quickly ranking a long list of listings; cap rate is the better number once a property is worth a closer look.
Compare and common questions
Cap Rate: frequently asked questions
What is considered a good cap rate?
There is no single good cap rate; it depends on the property type, location, condition and interest rates. A higher cap rate pays more income per dollar but usually signals more risk or less expected growth, so compare a property with similar, recently sold ones in the same market.
Is a higher cap rate always better?
No. A higher cap rate means more income relative to price, but it often reflects higher vacancy risk, an older building or a weaker location. A lower cap rate can be a better investment if the income is more secure or expected to grow.
Does cap rate include mortgage payments?
No. Cap rate uses net operating income, which is calculated before principal and interest. To see the return after financing, use cash-on-cash return or DSCR.
What is the difference between cap rate and cash-on-cash return?
Cap rate measures the property's income against its full price, ignoring the loan. Cash-on-cash return measures cash flow after mortgage payments against the cash you actually invested, so it changes with the down payment and the interest rate.
How do I use cap rate to estimate value?
Divide NOI by a market cap rate: $24,000 of NOI at a 6% cap rate implies a value of $400,000. The estimate is only as reliable as the NOI and the cap rate you choose.
Go deeper
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Run Cap Rate with your own numbers:
Where it fits
- Investing, Acquisition: next, Net Operating Income.
More Investing Terms
Recommended next step
Run the cap rate with your own rent, vacancy and expenses.
Cap rate calculator →Apply it to a specific property: Cap rate analysis for a specific property, Rental property analysis.
Sources and review
No regulator defines this term; the page follows common industry practice.
Where this applies: Industry convention - no single regulatory definition. Lenders and appraisers may define inputs differently.
Last reviewed: · Updated:
Examples use illustrative figures; rules of thumb are labelled as such. Rates, limits and program rules change - confirm current figures with your lender or a qualified professional.
This definition is provided for general educational purposes and is not financial, legal, tax, or real estate advice. Verify important decisions with appropriately qualified professionals.
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