What is cap rate?
The capitalization rate — cap rate — is the most widely used metric for evaluating income-producing real estate. It measures the annual return a property generates relative to its value, assuming an all-cash purchase. Cap rate strips out financing so you can compare properties on the same footing regardless of how they're funded.
The formula is straightforward: Cap Rate = Net Operating Income ÷ Property Value. A property generating $24,000 of NOI purchased for $400,000 has a 6% cap rate. The inverse is also true — if you know a market trades at 6% cap rates, a property with $24,000 NOI should be worth roughly $400,000.
The cap rate formula
What goes into NOI — and what doesn't
Getting NOI right is where most beginner investors make mistakes. NOI is income after operating expenses but before mortgage payments, depreciation and income taxes. It is a property-level metric, not an investor-level metric.
Included in NOI
- Gross rent (all units)
- Less: vacancy & credit loss
- Less: property taxes
- Less: insurance
- Less: property management fees
- Less: maintenance & repairs
- Less: utilities (landlord-paid)
- Less: HOA / common area costs
Not included in NOI
- Mortgage principal & interest
- Depreciation
- Income tax
- Capital expenditures (roof, HVAC)
- Loan origination fees
- Personal expenses
- Closing costs at purchase
- Investor's own management time
Capital expenditures (CapEx) are often omitted from NOI because they are not recurring operating expenses. That does not make them economically irrelevant. Model a property-specific replacement reserve and acquisition costs separately so the cap rate does not hide roofs, HVAC systems, or other irregular capital needs.
How to interpret a cap rate
There is no durable national table of “good” cap rates. The figure varies with property type, condition, leases, expenses, location, growth expectations, liquidity, and the date of valuation. A higher cap rate can indicate more current income, more risk, or both.
| Compare | Keep constant | What to investigate |
|---|---|---|
| Two properties | Valuation date and NOI method | Condition, tenants, leases and deferred work |
| Two neighborhoods | Property type and quality | Vacancy, demand, regulation and liquidity |
| Purchase vs current value | The same normalized NOI | Whether the denominator answers your question |
| Cap rate vs financing | Unlevered property cash flow | Debt service and cash invested separately |
For a live benchmark, use recent comparable transactions for the same asset type and normalize their NOI on the same basis. Listing cap rates are not substitutes for verified income, expenses, and sale prices.
Cap rate vs cash-on-cash return
Cap rate and cash-on-cash (CoC) return are related but measure different things. Cap rate is financing-agnostic — it tells you about the property. Cash-on-cash measures your actual cash return on the equity you deployed, including the effect of leverage.
In this illustration, leverage produces a cash-on-cash return close to the cap rate. Leverage works both ways: if NOI falls, cash flow shrinks while scheduled debt service remains. The result changes with the actual interest rate, loan terms, closing costs, and reserves.
The cap rate and interest rate relationship
Interest rates can affect required returns, financing costs, and property values, but cap rates do not move in a fixed spread to the 10-year Treasury. Property income growth, risk, transaction liquidity, leverage availability, and local supply can change the relationship.
| Scenario input | Potential effect | What to test |
|---|---|---|
| Higher borrowing cost | Lower leveraged cash flow | Debt-service coverage and cash-on-cash return |
| Higher required return | Downward pressure on value | Value at several exit cap rates |
| Stronger expected NOI growth | May support a lower going-in cap | Rent, vacancy and expense assumptions |
Cap rate is a valuation and comparison tool — not a measure of your actual return. A 7% cap rate in Indianapolis is not the same investment as a 4% cap rate in San Francisco: risk profile, liquidity, appreciation potential and tenant quality differ significantly. Use cap rate to screen and compare deals, then model the full return including leverage, CapEx reserves, tax benefits and exit assumptions before committing capital.