Cap rate explained
Capitalisation rate is one number divided by another:
Cap rate = net operating income ÷ property value
A property producing $18,000 of net operating income at a $300,000 price has a 6% cap rate. It measures the return the property produces before any financing, which is what makes two properties of different sizes comparable.
The division is trivial. The whole difficulty is the numerator, and that is where most of the disagreement in any transaction lives.
What belongs in net operating income#
| In NOI | Not in NOI |
|---|---|
| Gross rent, actually collected | Mortgage principal and interest |
| Other income — laundry, parking, fees | Depreciation |
| Less: property tax | Capital expenditure |
| Less: insurance | Income tax |
| Less: management | Loan fees and points |
| Less: maintenance and repairs | Owner's own labour, usually |
| Less: vacancy allowance | |
| Less: utilities you pay | |
| Less: licensing, HOA, landscaping, snow |
Financing is excluded deliberately. Cap rate describes the property. Two buyers with different loans on the same building should compute the same cap rate, and the one that includes their mortgage has computed something else.
Capital expenditure is excluded and it still exists. A new roof does not appear in NOI, which is why a property with an excellent cap rate and a roof at end of life is not the deal it looks like. Reserve for capital separately and subtract it from your own expectations rather than from NOI.
Run your own numbers in the cap rate calculator — it builds net operating income from the actual expense lines and values a property from its income at a market rate.
The three numbers problem#
The same property routinely produces three different cap rates.
The seller's cap rate. Market rent rather than collected rent, no vacancy allowance, management excluded because they self-manage, maintenance at an optimistic figure. This is not necessarily dishonest — a seller who genuinely self-manages has no management line — but it describes their operation rather than yours.
The broker's cap rate. Somewhere between, often using a standard expense ratio rather than actual figures.
Your cap rate. Collected rent, a real vacancy allowance, management at what you will actually pay, and maintenance appropriate to the age of the building.
Worked, on the same property:
| Line | Seller's version | Yours |
|---|---|---|
| Gross annual rent | $36,000 market | $33,600 collected |
| Vacancy allowance | $0 | −$2,016 (6%) |
| Property tax | −$4,200 | −$4,800 non-homestead |
| Insurance | −$1,100 | −$1,600 landlord policy, real quote |
| Management | $0 self-managed | −$3,024 (9%) |
| Maintenance | −$1,800 | −$3,400 (old stock) |
| NOI | $26,900 | $18,760 |
| At a $300,000 price | 9.0% cap | 6.3% cap |
Nothing about the building changed. Two of those expense lines are simply absent from the first column and three are understated, and the headline moves by nearly three points.
Which is why "what is a good cap rate" is unanswerable in the abstract. A 9% quoted cap and a 6.3% real one describe the same asset.
What a good cap rate actually is#
It is whatever comparable properties recently traded at in that submarket.
That is not evasion. Cap rates are set by the market for a reason — they price risk, growth expectation and liquidity — and a property trading well outside the local range is telling you something rather than presenting an opportunity.
What drives a market's cap rates:
| Higher cap rates | Lower cap rates |
|---|---|
| Declining or flat population | Growth |
| Older housing stock | Newer construction |
| Concentrated employment | Diversified economy |
| Thin buyer pool | Deep, liquid market |
| Higher tenant turnover | Stable, long tenancies |
| Landlord-unfriendly law | Faster, cheaper enforcement |
| Heavy property tax burden | Lower effective rates |
A high cap rate is compensation. For a declining submarket, for capital needs, for tenant risk, or for the fact that selling will take longer than buying did. Occasionally it is genuine mispricing, and that is rare enough to be worth checking hard rather than assuming.
Where cap rate does not work well#
Single-family rentals. Priced largely against owner-occupied comparable sales rather than against income. A single-family house in a desirable school district is priced by families, and its cap rate is a consequence of that price rather than a cause. Useful for comparing your own candidates; not useful for explaining what the market is doing.
Small multifamily under five units. Financed as residential and often priced partly on comparable sales, so the same distortion applies in weaker form.
Properties with heavy deferred capital. NOI ignores the roof. Two identical cap rates on a building with a new roof and one needing a roof are not the same investment.
Owner-occupied and mixed-use. Where part of the space produces no rent, NOI is not comparable to a fully leased property.
Where it works properly is commercial and larger multifamily, which trade on income and where market cap rates genuinely explain price.
Cap rate, cash-on-cash and the rest#
| Metric | Formula | Answers |
|---|---|---|
| Cap rate | NOI ÷ price | How does this asset perform, ignoring financing |
| Cash-on-cash | Annual cash flow ÷ cash invested | What does my money earn |
| Gross rent multiplier | Price ÷ annual gross rent | Rough screen, ignores expenses |
| Debt service coverage | NOI ÷ annual debt service | Will a lender fund it |
| Total return | Cash flow + principal + appreciation | The whole picture |
Cap rate compares assets. Cash-on-cash compares purchases. They answer different questions and a buyer needs both — the first to know whether the price is sensible, the second to know whether the deal works for them.
Leverage separates them. A 6% cap property bought with a 5% loan produces a cash-on-cash return well above 6%. The same property with a 7% loan produces negative leverage, where borrowing reduces the return rather than amplifying it. The cap rate is identical in both cases.
Two calculations, worked#
Cap rate. Property at $300,000, NOI $18,760.
$18,760 ÷ $300,000 = 6.25%
Cash-on-cash. Same property, 25% down at $75,000 plus $8,000 closing and $5,000 make-ready, so $88,000 invested. Annual debt service on $225,000 at current rates, say $16,400.
Annual cash flow = $18,760 − $16,400 = $2,360
Cash-on-cash = $2,360 ÷ $88,000 = 2.7%
A 6.25% cap rate producing a 2.7% cash-on-cash return is a normal and sobering result at current borrowing costs, and it is the calculation that should be done before an offer rather than after a closing.
Add principal paydown and any appreciation and the total return is higher. Cash flow alone is thinner than most projections assume.
What the numbers do not capture#
Capital expenditure timing. A furnace at year fifteen and a roof at year twenty are certainties, not risks, and they do not appear anywhere in these formulas.
Eviction cost and duration, which vary from weeks to months by state and land entirely outside NOI as it is usually presented.
Licensing and inspection regimes. City-level in most of the Midwest, with real fees and real consequences for non-compliance.
Insurance trajectory. Rising unevenly, and a quote today is not a cost forever. Older stock with an original roof prices worse each year.
The exit. A high-yield property in a thin market takes longer to sell, and the buyer will be another investor running the same arithmetic you are.
Cap rate as a valuation tool#
The formula runs both ways, and this is where it earns its keep on income property.
Value = NOI ÷ cap rate.
If comparable buildings in a submarket trade at a 7% cap and a property produces $28,000 of NOI, the market is saying it is worth about $400,000.
Which means you can create value by raising NOI. On a 7% cap, every $1,000 of additional annual NOI adds roughly $14,300 of value. That is the arithmetic behind almost every value-add strategy:
| Action | Annual NOI change | Value created at 7% cap |
|---|---|---|
| Raise rent $50/month on four units | +$2,400 | ~$34,300 |
| Bill back water and sewer | +$1,800 | ~$25,700 |
| Add coin laundry | +$1,200 | ~$17,100 |
| Reduce turnover from annual to biennial | +$1,500 | ~$21,400 |
| Appeal a property tax assessment | +$800 | ~$11,400 |
A $12,000 renovation that supports $50 more rent per unit across four units returns nearly three times its cost in value — provided the market cap rate holds and the rent is actually achievable.
Two cautions. This works where the market prices on income, so it works on commercial and larger multifamily and works poorly on single-family. And the cap rate itself moves: value created by raising NOI can be erased by cap rates expanding, which is what happens when interest rates rise.
Cap rate compression and expansion#
The number most owners treat as fixed and which moves more than rents do.
Compression — cap rates falling — means buyers accept lower returns, so prices rise on unchanged income. It follows falling interest rates, capital flowing into a market, and improving confidence.
Expansion — cap rates rising — means the opposite. Prices fall on unchanged income.
The arithmetic is unforgiving. A property with $28,000 NOI:
| Market cap rate | Implied value |
|---|---|
| 5% | $560,000 |
| 6% | $466,700 |
| 7% | $400,000 |
| 8% | $350,000 |
A movement from 6% to 7% removes $66,700 of value with nothing changing about the building. Rent growth of 3% a year would take four years to offset it.
Which is the risk in buying at a compressed cap rate, and the reason a seemingly expensive market can stay expensive or correct sharply. It is also why the cap rate at which you buy matters more to eventual returns than most buyers, focused on monthly cash flow, appreciate.
The expense ratio shortcut, and where it fails#
A common screening habit: assume operating expenses run 40% to 50% of gross rent, and derive NOI from that.
It is a reasonable first pass and a poor basis for an offer.
Where the ratio runs low: newer construction, tenants paying all utilities, low property tax jurisdictions, self-managed, larger buildings spreading fixed costs.
Where it runs high: pre-1960 stock, owner-paid heat — common in older Midwest multifamily — high property tax states, heavy snow and lawn obligations, small buildings, and any city with an active licensing and inspection regime.
On a 1920s Minneapolis fourplex with owner-paid heat, an expense ratio of 55% to 60% is realistic, and applying a 45% assumption overstates NOI by enough to move the cap rate a full point.
Build the expenses line by line on anything you intend to buy. The ratio is for deciding what to look at, not what to pay.
Before relying on a cap rate#
- Rebuild NOI yourself from collected rent, not market rent.
- Include management even if you intend to self-manage — you may not always.
- Use a real insurance quote on the actual property.
- Use the non-homestead property tax rate if you will not occupy it.
- Set maintenance by the age of the building, not a flat percentage.
- Add a vacancy allowance appropriate to the submarket.
- Reserve for capital separately and know the age of the roof, furnace and water heater.
- Compare against local sales, not a national benchmark.
- Then calculate cash-on-cash, because that is what your money actually earns.