The capitalization rate — or cap rate — is one of the most widely used metrics in real estate investing. It tells you how much annual income a property generates relative to its purchase price, expressed as a percentage. Before you make an offer on any investment property, you need to know this number.
The cap rate won't tell you everything, but it gives you a fast, standardized way to compare properties across different markets, price points, and property types — without financing assumptions clouding the picture.
The Cap Rate Formula
Two variables drive this formula. First, Net Operating Income (NOI) — which is your gross rental income minus all operating expenses, but before debt service. Second, property value — either the purchase price or the current market value depending on what you're calculating.
Step-by-Step: Calculating Cap Rate
Step 1 — Calculate Gross Annual Rent
Start with what the property produces at full occupancy. If a property rents for $2,200/month, gross annual rent is $2,200 × 12 = $26,400. Don't include future rent increases or optimistic assumptions at this stage.
Step 2 — Apply a Vacancy Factor
No rental property stays 100% occupied every year. A standard vacancy allowance is 5–8% for most stabilized markets. In high-demand urban areas, 3–5% is reasonable. In slower markets, use 8–10%. On $26,400 gross rent with a 7% vacancy assumption, your effective gross income drops to $24,552.
Step 3 — Subtract Operating Expenses
Operating expenses are everything that costs money to run the property, excluding mortgage payments. Common categories include:
- Property taxes
- Insurance premiums
- Property management fees (typically 8–12% of collected rents)
- Repairs and maintenance
- Capital expenditure reserves (roof, HVAC, appliances)
- Utilities (if landlord-paid)
- Accounting and legal fees
A common rule of thumb is that operating expenses run 35–50% of gross rental income for single-family rentals. For multifamily, they tend to run slightly higher. Use real numbers from the seller's records whenever possible — and verify them.
Step 4 — Calculate NOI
NOI = Effective Gross Income − Operating Expenses
What Is a Good Cap Rate?
There is no universal "good" cap rate — it depends entirely on the market, property type, and your investment goals. That said, here are common benchmarks:
- 3–5%: Typical for high-demand coastal markets (NYC, LA, Seattle, Vancouver). Low cap rates usually reflect strong appreciation expectations.
- 5–7%: Solid range for mid-tier markets. Balances cash flow with reasonable risk.
- 7–10%+: Found in emerging or secondary markets. Higher income yield, but often comes with higher management intensity or risk.
Key insight: Cap rate and property price move inversely. When buyers pay more for the same income stream, the cap rate compresses. A rising cap rate environment (like higher interest rate periods) means property values tend to fall even if rents stay flat.
Cap Rate vs. Cash-on-Cash Return
Cap rate ignores financing. It measures the property's performance as if you bought it with all cash. Cash-on-cash return, on the other hand, measures your actual return on the dollars you invested — including the effect of your mortgage.
Use cap rate to compare properties on an apples-to-apples basis. Use cash-on-cash return to evaluate your actual leveraged returns based on your specific financing terms. Both metrics belong in every deal analysis.
What Cap Rate Doesn't Tell You
Cap rate is a snapshot metric, not a complete picture. It doesn't account for:
- Financing costs (mortgage payments)
- Future rent growth or appreciation
- Tax benefits (depreciation, deductions)
- The quality or condition of the property
- Tenant stability or lease terms
Always pair your cap rate analysis with a full cash flow model and a look at the property's physical condition. A 9% cap rate on a property that needs $50,000 in deferred maintenance is not what it appears to be.
How to Use Cap Rate When Making Offers
If you know the NOI of a property and have a target cap rate in mind, you can work backward to determine what you should pay. This is called income-based valuation:
This approach gives you an offer ceiling grounded in financial performance, not emotion. It's especially powerful when negotiating with sellers who are pricing on comparable sales rather than income.