Cap rate = NOI / purchase price. It measures a property\'s unlevered yield.
Cap rate
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Net operating income (NOI)
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Operating expense ratio
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The yardstick that ignores your mortgage
Capitalization rate is the cleanest way to compare two properties on equal footing, because it strips out how you finance the deal. Two investors can buy the identical building, one paying all cash and one borrowing 80 percent, and they will earn wildly different returns on their own money. But the building itself produces the same income either way, and cap rate measures that. It answers a single question: if you paid cash, what annual yield would this property throw off in its first year?
The formula is net operating income divided by purchase price. Net operating income, or NOI, is your gross rent minus every operating expense the property demands. Critically, it does not subtract the mortgage. Debt service is a financing choice, not a property expense, so it lives outside the cap rate entirely. The metric that folds in your loan is cash-on-cash return, which is a different question for a different page.
Running a $300,000 rental
The defaults model a typical single-family rental. Gross rent is $30,000 a year. Operating expenses, covering property tax, insurance, maintenance, management, and the like, total $9,000. NOI is therefore $30,000 less $9,000, which is $21,000. Divide that by the $300,000 purchase price and the cap rate is 7.0 percent. The tool also reports the operating expense ratio, which is $9,000 divided by $30,000, or 30 percent. That ratio is a useful gut check: residential rentals commonly run an expense ratio somewhere in the 35 to 50 percent range once you account for vacancy and capital reserves, so a clean 30 percent suggests your expense estimate may be optimistic.
| Line | Amount |
|---|---|
| Annual gross rent | $30,000 |
| Operating expenses | $9,000 |
| Net operating income, rent less expenses | $21,000 |
| Purchase price | $300,000 |
| Cap rate, $21,000 divided by $300,000 | 7.0 percent |
| Operating expense ratio | 30 percent |
Why the same income can be priced differently
Cap rate and price move in opposite directions for a fixed income stream. The chart holds NOI constant at $21,000 and shows what the market would pay at different cap rates. A buyer demanding a 5 percent cap pays $420,000 for that income, while one demanding 8 percent pays only $262,500. Lower cap rates signal safer markets and richer pricing, higher cap rates signal more risk or weaker locations and a cheaper entry point.
Using cap rate without being fooled by it
This tool is for rental and commercial investors comparing deals, and for anyone trying to back into a fair offer price from a property's income. A tip that separates careful buyers from burned ones: build a real NOI, not the seller's NOI. Listing pro formas routinely omit vacancy, property management, and capital reserves to inflate the cap rate. Add a vacancy allowance of at least 5 percent of gross rent, a management fee whether or not you self-manage, and a reserve for the roof and systems that will eventually fail. A cap rate built on honest expenses is often a full point or two below the marketing number.
The biggest mistake is comparing cap rates across different markets as if they were interchangeable. A 4 percent cap in a coastal metro and a 9 percent cap in a tertiary town are not telling you the second deal is better. They are telling you the market prices in different growth and risk. Cap rate also says nothing about appreciation, which in some markets is where most of the long-run return actually comes from. Use it to compare like with like, then look past it for the full picture. Note that the rental income behind your NOI is reported on Schedule E, where mortgage interest and depreciation, neither of which touches cap rate, will shape your actual tax bill.
Is a higher cap rate always better?
Not at all. A higher cap rate means a cheaper price for the income, but it usually comes with more risk, slower appreciation, or a tougher location. A lower cap rate often reflects a safer, more liquid market. The right cap rate is the one that fairly compensates you for the specific risk of that property, not simply the largest number you can find.
Should property management be in my expenses even if I self-manage?
Yes, include it. Your time has value, and someday you may hand the property to a manager or a buyer who will. Leaving out an 8 to 10 percent management fee overstates NOI and flatters the cap rate. Underwriting with a management cost gives you a number that survives a change in your circumstances.
How does cap rate relate to a property's value over time?
If you can grow NOI while the market cap rate holds steady, the property's value rises in lockstep, which investors call forced appreciation. Raising rent or trimming expenses by a few thousand dollars of annual NOI can add far more than that to value at a typical cap rate. This is the core mechanism behind value-add real estate strategies.