When you start analyzing rental properties, you'll encounter one metric more than any other: the capitalization rate, or cap rate. This single number helps investors quickly compare properties across different price points, locations, and sizes. Understanding cap rate—what it measures, how to calculate it, and crucially, what it doesn't tell you—is fundamental to evaluating investment real estate.
The appeal of cap rate is its simplicity. It reduces a complex investment decision to a single percentage that represents the unleveraged return you'd earn if you bought the property outright. But that simplicity comes with trade-offs. Cap rate provides a snapshot, not a complete picture, and relying on it exclusively will lead to poor investment decisions.
What Is Cap Rate?
Cap rate expresses the relationship between a property's net operating income (NOI) and its value or purchase price. In plain terms, it answers the question: if I paid cash for this property, what annual return would I earn on that investment based purely on the property's income?
The formula is straightforward: Cap Rate = Net Operating Income ÷ Property Value. A property generating $45,000 in annual NOI and priced at $500,000 has a 9% cap rate. That percentage tells you the income return you'd receive relative to your investment—before considering financing, taxes, or appreciation.
Cap rate works both directions. If you know the NOI and want to estimate value, divide NOI by the market cap rate for similar properties. If a market typically trades at a 7% cap rate and your property generates $70,000 NOI, the implied value is $1 million ($70,000 ÷ 0.07). This is how commercial real estate is often valued—not by comparable sales like residential properties, but by capitalizing income at market-appropriate rates.
How to Calculate Cap Rate
The accuracy of your cap rate calculation depends entirely on your NOI number. Net Operating Income equals gross rental income minus operating expenses—but what counts as operating expenses matters. Include property taxes, insurance, property management fees, maintenance and repairs, utilities paid by the landlord, landscaping, and vacancy allowance. Do not include mortgage payments, capital expenditures, depreciation, or income taxes—those aren't operating expenses.
Consider a duplex purchased for $400,000. Each unit rents for $1,400 monthly, generating $33,600 in gross annual rent. You estimate 5% vacancy ($1,680), bringing effective gross income to $31,920. Operating expenses include property taxes ($3,800), insurance ($1,200), maintenance budget ($2,400), property management at 8% of rent ($2,554), and miscellaneous expenses ($500)—totaling $10,454. Your NOI is $21,466, yielding a cap rate of 5.4%.
The biggest calculation mistakes involve underestimating expenses. New investors often use the numbers sellers provide without scrutinizing them. Sellers have incentive to minimize reported expenses (showing a higher NOI and justifying a higher price). Always verify property taxes with the county assessor, get insurance quotes yourself, and budget realistically for maintenance and vacancy. The "1% rule" suggesting monthly rent should equal 1% of purchase price is a quick screening tool, but proper cap rate analysis requires detailed expense accounting.
What's a Good Cap Rate?
Cap rates vary enormously by market, property type, and condition. A 5% cap rate might be excellent in San Francisco but disappointing in Cleveland. Understanding why helps you interpret the numbers.
Lower cap rates (3-5%) typically indicate lower perceived risk. You'll find these in expensive coastal markets with limited supply, strong rent growth potential, and stable economies. Properties in these areas may appreciate significantly, and investors accept lower current income in exchange for safety and upside. Class A properties in prime locations—think new construction with premium tenants in desirable neighborhoods—command lower cap rates.
Mid-range cap rates (5-7%) represent balanced risk and return. Many solid rental properties in stable secondary markets fall into this range. You're getting reasonable current income from properties that may not appreciate dramatically but should hold value and remain rentable.
Higher cap rates (7-10%+) signal greater perceived risk—or opportunity. Properties in less desirable neighborhoods, those needing significant work, or markets with economic challenges trade at higher cap rates. Sometimes this reflects genuine risk; sometimes it reflects markets that are undervalued. Value-add investors specifically target high cap rate properties where they can improve operations or the physical asset and eventually sell or refinance at a lower cap rate.
The key insight is that cap rate reflects risk perception, not quality. A 4% cap rate isn't "better" than an 8% cap rate—they represent different risk-return profiles. Your investment strategy determines which makes sense for you.
What Cap Rate Doesn't Tell You
Cap rate has significant blind spots that trip up investors who rely on it too heavily.
It ignores financing. Most investors use leverage, and the terms of your financing dramatically affect actual returns. Two properties with identical cap rates could produce vastly different cash-on-cash returns depending on down payment, interest rate, and loan terms. A property with a 6% cap rate financed with a 4% mortgage generates positive leverage—your returns exceed the cap rate. Finance that same property at 7% interest and leverage works against you.
It ignores appreciation. In markets with strong price growth, a lower cap rate property might deliver better total returns than a higher cap rate property in a stagnant market. Cap rate only measures current income return, missing the equity building from mortgage paydown and property appreciation.
It assumes stable income. Cap rate represents a snapshot at current rents. A property with below-market rents has upside that cap rate doesn't capture. Conversely, a property with above-market rents or an unusually low vacancy might show an artificially high cap rate that won't persist.
It doesn't distinguish between property condition. A deferred maintenance nightmare and a well-maintained building might have similar cap rates, but the first one has capital expenditure needs that will eat into real returns. Cap rate doesn't account for future capital requirements.
Beyond Cap Rate: Other Essential Metrics
Cash-on-cash return measures the actual cash you earn relative to the cash you invested. It accounts for financing and is more relevant to leveraged investors than cap rate. If you put $100,000 down and generate $8,000 in annual cash flow after all expenses including debt service, your cash-on-cash return is 8%.
Gross rent multiplier (GRM) offers even quicker screening than cap rate. Divide price by annual gross rent—a $300,000 property generating $36,000 in gross annual rent has a GRM of 8.3. Lower GRMs suggest better value, but GRM ignores expenses entirely, making it less precise than cap rate.
Internal rate of return (IRR) provides the most complete picture by incorporating all cash flows over time, including purchase, ongoing income, and eventual sale. IRR is the discount rate that makes the net present value of all cash flows equal zero. It's more complex to calculate but captures appreciation, mortgage paydown, and the time value of money.
Smart investors use these metrics in combination. Cap rate for initial screening and market comparison. Cash-on-cash for understanding actual returns with your financing. IRR for long-term hold analysis and comparing different investment opportunities.
When comparing cap rates across markets, research the local context. A 6% cap rate in Austin means something different than a 6% cap rate in Pittsburgh because market growth, rent trends, and economic fundamentals differ. Cap rate compares properties within a market better than across markets.