What Is Cap Rate? A Complete Guide

Definition

Cap rate (capitalization rate) is a ratio that measures an investment property's expected annual return based on its net operating income (NOI) relative to its market value. It is expressed as a percentage.

Cap rate is a property-level metric. It does not depend on how the property is financed — mortgage terms, interest rates, and down payment size do not affect cap rate. This makes it useful for comparing properties objectively, independent of investor-specific financing.

The Formula

Worked Example

Suppose a property generates $42,000 in annual gross rent. With a 5% vacancy rate, effective gross income is $39,900. Annual operating expenses (tax, insurance, management, maintenance) total $12,000.

• NOI = $39,900 − $12,000 = $27,900
• Purchase price = $450,000
• Cap Rate = $27,900 ÷ $450,000 × 100 = 6.2%

This means the property generates 6.2 cents of net income for every dollar of property value, before considering financing.

How Cap Rate Is Used

• Property comparison: Two properties with similar financials can be compared by cap rate. A higher cap rate generally implies higher income yield at that price.
• Value estimation: Appraisers use cap rates from comparable sales to estimate property value: Value = NOI ÷ Cap Rate.
• Market benchmarking: Institutional investors use cap rates to assess market pricing. Rising prices with stable NOI produce lower cap rates (cap rate compression).

Cap Rate Compression

Cap rate compression occurs when property values rise faster than income. If a property previously priced at a 7% cap rate is now priced at a 5% cap rate — with the same NOI — it simply means buyers are paying more for that income stream.

From the cap rate formula: if NOI stays constant and cap rate falls, property value must have risen. This is often seen in high-demand markets.

The Inverse Relationship

Cap rate and property value move inversely for a given NOI. A property with $30,000 NOI is worth:

• At 5% cap rate: $600,000
• At 6% cap rate: $500,000
• At 8% cap rate: $375,000

This means higher cap rates imply lower prices relative to income — not necessarily better or worse, but a different risk/return profile.

Cap Rate vs Cash-on-Cash Return

Use cap rate to compare properties and assess market pricing. Use cash-on-cash return to evaluate your specific investment return after financing.

Limitations of Cap Rate

• No financing: Cap rate tells you nothing about how financing affects your actual return.
• No appreciation: Cap rate is a snapshot. It does not account for future price appreciation or depreciation.
• Stabilized assumption: Cap rate assumes the property is operating normally. It does not model major vacancies, lease-up periods, or turnaround situations well.
• Market-dependent: A "good" cap rate varies by market, location, property type, and risk. Always compare to local comps — not generic benchmarks.
• Operating expense assumptions: Different investors may calculate NOI differently. Make sure you are comparing apples to apples.

Frequently Asked Questions