Cap rate
Investing & metrics
Definition
Net operating income divided by purchase price, expressed as a percentage. It compares properties independently of how they are financed, which is exactly why it excludes mortgage payments — two buyers with different loans get the same cap rate.
Photo: Nataliya Vaitkevich · Pexels
What it means
Capitalization rate, or cap rate, is a property's annual net operating income divided by its value, expressed as a percentage.
Cap rate = NOI ÷ price.
On the canonical property: $20,530 of NOI on a $310,000 purchase is a cap rate of 6.62%.
What it expresses is the unleveraged annual return the property produces, before financing and before tax. Because it excludes the mortgage entirely, it describes the asset rather than the buyer — which is what makes it comparable across properties and across investors.
The formula rearranges three ways, and the second is the one that does most of the work in practice:
- NOI ÷ price = cap rate — what return does this property give at this price?
- NOI ÷ cap rate = value — what is this property worth, given what the market pays?
- Price × cap rate = NOI — what income does this price require?
A lower cap rate means a higher price for the same income: buyers accept less return where they expect growth, low risk, or strong demand. A higher cap rate means the opposite. Cap rate is therefore a price signal about risk, not a quality score.
Why it matters
Cap rate is how income property is valued, which makes it the mechanism by which operating decisions turn into capital value.
The relationship is direct. At a market cap rate of 6.62%, each $1,000 of additional annual NOI adds about $15,100 of value. A $50-a-month rent increase — $600 a year — adds roughly $9,100. Cutting $720 a year off an insurance premium adds about $10,900. This is why operating discipline in a rental is not just about cash: it capitalises.
It is also the fastest sanity check on an asking price. A property listed at $380,000 producing $20,530 of NOI is a 5.4% cap rate. If comparable properties in that market trade at 6.5%, the listing is asking about $64,000 more than the income supports, and the buyer is paying for something other than the current income.
The critical caveat is that cap rate is only as reliable as the NOI behind it, and NOI is the number most easily flattered. A seller's cap rate typically uses last year's actual vacancy rather than a normal one, omits management because the owner self-managed, and excludes any reserve for capital spending. Each of those inflates NOI, and every dollar of inflation shows up multiplied in the price.
How it works in practice
Compute it on your own numbers, then compare it to the market's.
| Cap rate, canonical property | Amount |
|---|---|
| Net operating income | 20,530.00 |
| Purchase price | 310,000.00 |
| Cap rate as presented | 6.62% |
| Normalised vacancy at 6.6% | (1,900.80) |
| Management at 8% of rent | (2,304.00) |
| Capital reserve | (1,200.00) |
| Adjusted NOI | 15,125.20 |
| Adjusted cap rate | 4.88% |
The same property is a 6.6% deal or a 4.9% deal depending entirely on which NOI you use. Neither figure is dishonest; they answer different questions. The first says what the property produced last year under this owner. The second says what it would produce for a buyer who pays for management, expects normal vacancy, and reserves for a roof.
Use it for comparison, not for decision. Cap rate says nothing about financing, so two properties at the same cap rate can produce very different cash flow depending on the loan. It says nothing about growth, so a 5% cap rate in a market with rising rents may outperform a 8% cap rate in a declining one. And it says nothing about condition — a high cap rate frequently means deferred capital spending that the next owner inherits.
Where it is genuinely decisive is in valuing an improvement. If a $12,000 renovation raises rent by $150 a month, that is $1,800 of NOI, worth about $27,200 at a 6.62% cap rate. That is the calculation that tells you whether the work is worth doing, and it is not obvious from the rent increase alone.
Common mistakes
- Believing the seller's NOI. Normalise vacancy, add management, reserve for capital.
- Including the mortgage. Cap rate is unleveraged by definition; debt belongs in cash flow.
- Comparing across markets. A 7% cap rate means different things in different cities and asset types.
- Treating high as good. A high cap rate is usually the market pricing risk you have not identified yet.
- Using the asking price. The cap rate that matters is computed on what you actually pay, including closing costs — see cost basis.
- Ignoring reassessment. Property tax often resets on sale, so the buyer's NOI is lower than the seller's before anything else changes.
How BareBones PM helps
A cap rate is only useful if the NOI behind it comes from real records rather than an estimate typed into a spreadsheet.
BareBones PM keeps income and expenses per property, categorised so that operating expenses are separable from debt service and capital spending — which means NOI is derived from what actually happened rather than assembled at the point you need it.
Because rent, vacancy periods and arrears come from the lease ledger, effective gross income reflects collections, not the scheduled figure a seller would quote.
Capital improvements are tracked as their own items with dates and costs, so the reserve question — what has been spent on this building, and when — has an answer rather than a guess.
For how the underlying records are kept, see The rent ledger.
Photos: Nataliya Vaitkevich, RDNE Stock project · Pexels
Related terms
- Net operating incomeIncome after operating expenses but before mortgage payments, depreciation and capital spending. It measures the property itself rather than your financing, and it is the numerator behind cap rate and debt coverage.
- Gross rent multiplierPurchase price divided by annual gross rent. A fast back-of-envelope screen that ignores expenses entirely, which makes it useful for shortlisting and misleading for deciding.
- Cash-on-cash returnAnnual pre-tax cash flow divided by the cash you actually put in — deposit, closing costs, initial works. It answers what your money is earning, which cap rate deliberately ignores because it disregards financing.
- Operating expense ratioOperating expenses as a share of gross income. Useful for comparing properties and for sanity-checking a seller’s numbers — an unusually low ratio often means deferred maintenance rather than efficient management.