Capitalization rate — almost always shortened to cap rate — is one of the first numbers people look at when comparing income properties. It shows up in listings, appraisals and market reports, and it’s a quick way to put two very different properties on the same scale.
It’s also widely misunderstood. A cap rate isn’t a forecast of what an owner will earn, and it says nothing about financing. This guide covers what the number does measure, how to calculate it correctly, and how it relates to value.
The cap rate formula
Both pieces matter:
- Net operating income is the property’s annual income after vacancy and operating expenses, but before any mortgage payment. (There’s a full breakdown in our guide to rental cash flow.)
- Property value is usually the purchase price for a property being evaluated, or a current estimated value for one already owned.
The result is expressed as a percentage. A property with $30,000 of NOI and a $500,000 value has a 6% cap rate.
Why cap rate ignores the mortgage
Cap rate is an unlevered measure. It describes the property’s income relative to its price as if it were bought entirely with cash. That’s deliberate: the same building can be financed a hundred different ways, but its rent, expenses and price don’t change with the buyer’s loan.
Leaving debt out makes cap rate useful for comparing properties to each other. It also means cap rate can’t tell an investor what their own return on cash will be. For that, metrics such as cash-on-cash return bring the loan into the picture.
A worked example
A single-unit rental at $420,000
The property rents for $3,200 per month. The analysis uses a 5% vacancy allowance and $13,800 per year in operating expenses (taxes, insurance, management, maintenance and a CapEx reserve).
| Line item | Annual |
|---|---|
| Gross scheduled income ($3,200 × 12) | $38,400 |
| Vacancy allowance (5%) | −$1,920 |
| Effective gross income | $36,480 |
| Operating expenses | −$13,800 |
| Net operating income | $22,680 |
| Purchase price | $420,000 |
| Cap rate (NOI ÷ price) | 5.40% |
Hypothetical numbers for illustration.
Two quick variations show how the formula behaves:
- If the same property were priced at $380,000 instead, the identical NOI would produce a cap rate of 5.97%. A lower price means a higher cap rate.
- If NOI rose by $1,800 a year — through a rent increase or lower expenses — at the original price, the cap rate would become 5.83%.
Cap rate and value move in opposite directions
Rearranging the formula turns cap rate into a valuation tool:
Using the example property’s NOI of $22,680:
| Cap rate applied | Implied value |
|---|---|
| 6.0% | $378,000 |
| 7.0% | $324,000 |
This is how appraisers and commercial brokers often value income property: they estimate NOI and apply a cap rate drawn from recent sales of comparable properties. It also explains a phrase that comes up in market commentary — when cap rates compress (fall), values rise for the same NOI; when they expand, values fall.
What a “typical” cap rate looks like
There isn’t one. Cap rates vary by location, property type, building age, tenant profile and the interest-rate environment. A newer building in a high-demand area often trades at a lower cap rate than an older building in a slower market, because buyers are paying for perceived stability or growth.
That makes cap rate most meaningful as a comparison within a market and property type. Comparing a downtown apartment building’s cap rate to a rural single-unit rental’s says more about the two markets than about the two properties.
The inputs are where cap rates go wrong
Because the formula is so simple, the quality of a cap rate depends almost entirely on the NOI behind it. A few common issues:
Using gross rent instead of NOI. Dividing annual rent by price gives a gross yield, not a cap rate. The two can differ by several percentage points.
Leaving out expenses. Listing NOI figures sometimes exclude management, maintenance, CapEx or vacancy. Each omission inflates the cap rate.
Including the mortgage. Debt service is not an operating expense. Subtracting it produces cash flow, not NOI.
Mixing “actual” and “pro forma” numbers. A seller’s pro forma projects what a property could earn after changes. Actual (trailing) figures show what it did earn. Both are useful, but they answer different questions and shouldn’t be blended without saying so.
Cap rate vs. other return measures
Cap rate is one lens among several:
- Cash flow shows the monthly dollars left after the loan payment.
- Cash-on-cash return relates annual cash flow to the cash invested, so financing changes it.
- Gross yield uses rent alone and ignores expenses.
- Total ROI adds principal paydown and appreciation over a holding period.
Each answers a different question, and none of them replaces the others. Cap rate’s particular strength is that it isolates the property’s income relative to its price, independent of how it’s financed.
The takeaway
Cap rate is NOI divided by value — an unlevered snapshot of how much income a property produces for its price. It’s a strong comparison tool and a common valuation shortcut, but it’s only as good as the NOI behind it, and it deliberately leaves financing, appreciation and taxes out of the picture.