What Is Cap Rate in Real Estate?
The capitalization rate (cap rate) is one of the most fundamental metrics in real estate investing. It measures the rate of return on a property based on the net operating income (NOI) it generates relative to its market value or purchase price. Unlike metrics that factor in financing, the cap rate evaluates a property's performance as if it were purchased entirely with cash, making it ideal for comparing properties on an apples-to-apples basis.
Investors, appraisers, and lenders all use cap rates to quickly assess the potential return of an income-producing property. Whether you are evaluating a single-family rental, a multifamily apartment, or a commercial building, the cap rate gives you an instant snapshot of how hard your money is working.
How to Calculate Cap Rate
The cap rate formula is straightforward:
Cap Rate = (Net Operating Income / Property Value) x 100
Step 1: Calculate your Net Operating Income (NOI). This is the property's total annual income (rent, parking fees, laundry income, etc.) minus all operating expenses (property taxes, insurance, maintenance, management fees, vacancy allowance). Crucially, NOI does not include mortgage payments or depreciation.
Step 2: Divide the NOI by the property's current market value or the price you plan to pay.
Step 3: Multiply by 100 to express the result as a percentage.
For example, if a property generates $24,000 in annual NOI and is valued at $300,000, the cap rate is (24,000 / 300,000) x 100 = 8.0%.
What Is a Good Cap Rate?
There is no single "good" cap rate — the ideal number depends on the property type, location, market conditions, and your investment goals. Here are general benchmarks:
Below 4% — Core / Low-Risk Markets
Typical for prime urban locations (NYC, SF, LA), Class A properties, and long-term leased commercial assets. Lower returns but high stability and appreciation potential.
4% - 7% — Moderate / Balanced
Typical for suburban residential properties, small multifamily, and B-class commercial. A good balance of cash flow and stability for most investors.
8%+ — Value-Add / Higher Risk
Common for C-class properties, rural areas, or buildings needing significant work. Higher cash yields but typically more management-intensive and volatile.
Cap Rate vs. Cash on Cash Return
While both metrics measure return, they answer different questions. The cap rate ignores financing and tells you how the property performs on its own. The cash on cash return factors in your loan and measures the return on the actual cash you invest (your down payment, closing costs, etc.).
Use cap rate to compare properties and markets. Use cash on cash return to evaluate how well your personal investment dollars are working. For a complete picture, use both — or let Proformatic calculate everything automatically.
Frequently Asked Questions
Does cap rate include mortgage payments?
No. Cap rate uses NOI, which excludes mortgage payments (debt service). This is intentional — it lets you compare properties regardless of how they are financed. To see the impact of your loan, look at cash on cash return or DSCR instead.
Is a higher cap rate always better?
Not necessarily. A higher cap rate means more income relative to price, but it often reflects higher risk — vacancy concerns, deferred maintenance, or a declining area. Conversely, a low cap rate in a prime market can still be a strong investment due to appreciation and stability. Context matters.
How do I calculate NOI?
NOI = Gross Rental Income - Vacancy Allowance - Operating Expenses. Operating expenses include property taxes, insurance, repairs, maintenance, management fees, and utilities (if landlord-paid). They do not include mortgage payments, capital expenditures, or depreciation.
Can I use cap rate for single-family homes?
Yes, but with a caveat. Cap rate is most commonly used for multifamily and commercial properties where income is the primary driver of value. Single-family homes are often valued more by comparable sales than income. Cap rate is still useful for single-family rentals, but it should not be your only metric.
What is the difference between cap rate and ROI?
Cap rate looks at a single year's income relative to property value, without considering financing. ROI (return on investment) is broader and can factor in appreciation, tax benefits, loan paydown, and total invested capital over time. Cap rate is a quick screening tool; ROI gives you the full picture.