What a cap rate is

The capitalization rate, or cap rate, is a property's first-year net operating income (NOI) divided by its price. It ignores your loan. That makes it a fair way to compare two properties, whatever financing each buyer would use.

NOI is the rent you actually collect, minus operating costs such as taxes, insurance, repairs and management. It does not include the mortgage payment.

Think of it as the yearly yield if you paid all cash. A 7% cap rate means the property earns about 7 cents a year for each dollar of price, before any loan.

The formula

Cap rate = NOI / purchase price NOI = collected rent - operating expenses

What goes into operating expenses matters a great deal. Count property tax, insurance, repairs, a reserve for big replacements, management, utilities you pay and any HOA dues. Leave out the loan payment, depreciation and income tax.

Worked example

These are the calculator's starting numbers. Price: $250,000. Rent: $2,300 a month. Vacancy: 5%. Operating expenses: $9,000 a year.

  • Gross rent: $2,300 x 12 = $27,600
  • Vacancy: 5% of $27,600 = $1,380
  • Collected rent: $26,220
  • NOI: $26,220 - $9,000 = $17,220
  • Cap rate: $17,220 / $250,000 = 6.89%

I checked these against the calculator's math and they match. Now change one thing at a time. If the same building cost $200,000, the cap rate would be 8.61%. If expenses were $12,000 instead of $9,000, NOI would drop to $14,220 and the cap rate to 5.69%. Small changes in costs move the number a lot, which is why the expense line deserves your attention.

So what is good?

Think of the cap rate as the yield you would get if you paid all cash. Higher means more income per dollar of price. It often also means more risk, or an area or building that is harder to run. A lower cap rate often comes with steadier rent or a stronger chance of the price rising.

A useful way to judge it:

  • Compare it with other properties of the same type in the same area, using the same expense rules.
  • Compare it with your loan rate. If the cap rate is far below your interest rate, borrowing can drag your cash flow down.
  • Compare it with what else you could do with the money.

Notice that none of these gives a magic number. A rule of thumb is that cap rates differ by area, building type and market mood, so the same 6% can be fair in one place and poor in another. Ask local agents and lenders what similar sales are showing, and trust your own expense numbers over a seller's.

Cap rate and your loan

The cap rate ignores financing, so it does not tell you what you will earn on your own cash. For that, look at cash-on-cash return. It uses the cash flow left after loan payments and the cash you put in.

Here is a quick test. If your loan rate is higher than the cap rate, each borrowed dollar costs more than it earns. Cash flow gets thin fast. If the cap rate is well above the loan rate, borrowing can help. Lenders also look at DSCR, which compares NOI with loan payments.

Quick screens that go with it

Two fast checks often sit beside the cap rate. The gross rent multiplier is the price divided by a year of gross rent. In the example it is $250,000 / $27,600 = 9.06. The 1% rule asks whether monthly rent is at least 1% of the price. Here the rent is 0.92% of the price, so it falls just short. Use these to sort a long list quickly. Use the cap rate and a full cash flow check for the short list.

When it misleads

  • It uses year one only. Rent and costs change.
  • It depends on your expense numbers. If a seller leaves out repairs or management, the cap rate looks better than it is.
  • It ignores financing, so it does not show your cash flow or return on cash.
  • It says nothing about repairs a building needs soon.

Try the cap rate calculator to run your own numbers. It also shows the 1% rule and gross rent multiplier.

FAQ

Is a higher cap rate always better?

No. A high cap rate can mean a rougher area, heavier repairs or weaker demand. Judge it against the risk.

Should I use the seller's numbers?

Use them as a starting point, then replace them with your own estimates for vacancy, repairs and management.

How is cap rate different from cash-on-cash return?

Cap rate ignores your loan and uses the price. Cash-on-cash uses your cash flow after the loan payment and the cash you put in. Related: the 1% rule.

Does the cap rate include the mortgage?

No. NOI leaves out loan payments, so the cap rate is the same whether you pay cash or borrow.