What is Cap Rate?
Capitalization rate (cap rate) is one of the most important metrics in real estate investing. It measures the potential return on investment (ROI) of a rental property based on the income it generates relative to its purchase price.
Simple Definition
Cap rate shows you what percentage return you can expect from a property based on its current income, without considering financing costs.
The Cap Rate Formula
Understanding the Components:
Net Operating Income (NOI)
Annual rental income minus all operating expenses (property taxes, insurance, maintenance, property management, HOA fees, etc.). Does NOT include mortgage payments.
Property Purchase Price
The total cost to acquire the property. Some investors use current market value instead of purchase price when evaluating existing holdings.
Real-World Example
Sample Property Analysis:
Calculation:
Cap Rate = $21,000 ÷ $400,000 = 0.0525
Cap Rate = 5.25%
What's a Good Cap Rate?
There's no universal "good" cap rate—it depends on location, property type, market conditions, and your investment strategy. However, here are general guidelines:
Lower Cap Rate
Typically in prime locations with strong appreciation potential. Lower returns but more stable, less risky markets.
Average Cap Rate
Balanced markets with moderate risk and return. Most investors target this range for rental properties.
Higher Cap Rate
Often in emerging or higher-risk markets. Higher returns but may come with increased vacancy, maintenance, or market volatility.
Important Context:
- Major cities (NYC, SF, LA) often have lower cap rates (4-6%)
- Midwest and secondary markets typically have higher cap rates (8-12%)
- Class A properties usually have lower cap rates than Class C
Limitations of Cap Rate
While cap rate is valuable, it has limitations you should understand:
Doesn't Consider Financing
Cap rate doesn't account for mortgage payments, interest rates, or leverage effects. Two properties with identical cap rates can have very different cash-on-cash returns.
Ignores Appreciation
Cap rate only measures current income return, not property value appreciation over time.
Assumes Stable Income
Based on current NOI, which may fluctuate with vacancy rates, market rents, and expenses.
No Standard for Operating Expenses
Different sellers may calculate operating expenses differently, making comparisons difficult.
Calculate Cap Rate for Your Property
Use our free calculator to instantly calculate cap rate along with cash flow, ROI, and other essential investment metrics.
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