What is cap rate?
The capitalization rate, or cap rate, is a property’s yearly net operating income divided by its price. It tells you what the property earns on its price as if you paid all cash, so you can compare buildings without the loan getting in the way.
Net operating income (NOI) is the rent you actually collect after vacancy, minus the costs of running the property: taxes, insurance, repairs, utilities you pay and management. It leaves out mortgage payments, big one-time improvements and income tax.
Worked example
A triplex listed at $400,000 rents for $3,600 a month in total:
- Yearly rent of $43,200, less 5% vacancy, leaves $41,040 collected
- Operating costs: taxes $5,200, insurance $2,000, repairs $2,600, utilities $1,800 and 8% management ($3,283), for $14,883
- NOI: $41,040 − $14,883 = $26,157
Cap rate: $26,157 ÷ $400,000 = 6.54%.
If you want a 7% cap rate, the most you’d pay is $26,157 ÷ 7% = about $373,700, roughly $26,000 under the asking price.
What’s a good cap rate?
There’s no single number. Cap rates move with the market and the property:
- Location. Expensive, in-demand areas usually trade at lower cap rates because buyers expect steady rents and rising values. Smaller markets usually trade higher.
- Condition and risk. Older buildings, heavy repair needs or shaky rent rolls push cap rates up to make up for the risk.
- Your loan. If the cap rate is below your mortgage rate, borrowing usually lowers your return instead of raising it. That’s a quick sign the deal may not cash flow with a loan.
The most useful comparison is against similar properties that recently sold nearby, and against the return you need. That’s why this calculator asks for your target and shows the price that would hit it.
Cap rate vs. cash-on-cash return
Cap rate ignores financing. Cash-on-cash return includes the loan and measures the cash you get back each year against the cash you put in. A property can have a decent cap rate and still weak cash-on-cash if the interest rate is high. Use the cash-on-cash calculator to see that side.
Frequently asked questions
Does cap rate include the mortgage?
No. Cap rate measures the property’s return as if you paid cash. To include the loan, look at cash-on-cash return and cash flow.
Should I use the seller’s numbers?
Treat them as a starting point. Listings often leave out vacancy, management or repairs, which makes the cap rate look higher. Rebuild the costs yourself, using the real tax bill and an insurance quote.
Is a higher cap rate always better?
Not always. More income for the price often comes with more risk: a weaker location, an older building or less reliable tenants.
Do I include capital expenses like a new roof?
Most investors leave big one-time improvements out of NOI and budget for them separately. Ordinary repairs and maintenance go in.
Check the whole deal
Cap rate is one number. ElmCheck’s free deal analyzer adds the loan, cash flow, cash-on-cash return, DSCR, IRR, taxes and a buy, maybe or pass verdict.