What the cap rate tells you
The capitalization rate is the yearly return a property would produce if you bought it with cash. It ignores financing, so it lets you compare a duplex, a small apartment building and a retail unit on the same basis: how much net income each dollar of price buys.
Cap rate = net operating income (NOI) ÷ property value
NOI = (rent + other income) × 12 × (1 − vacancy) − operating expenses
Value at a target cap rate = NOI ÷ target cap rate
Operating expenses include property tax, insurance, repairs and maintenance, property management, utilities the owner pays, HOA or common-area costs, landscaping, trash and reserves for replacements. They do not include mortgage payments, depreciation or income tax.
Worked example
A fourplex priced at $500,000 rents for a total of $4,000 a month. Allowing 5% vacancy and $14,000 a year of operating expenses:
- Gross scheduled income: $4,000 × 12 = $48,000.
- Effective income: $48,000 × 0.95 = $45,600.
- NOI: $45,600 − $14,000 = $31,600 (expenses are 30.7% of income).
- Cap rate: 31,600 ÷ 500,000 = 6.32%.
If similar buildings in the area sell at a 6.5% cap rate, this NOI supports a value of 31,600 ÷ 0.065 = about $486,154, a little below the asking price. If buyers there want 7.5%, the value drops to about $421,333. That is why a small change in cap rate moves the price of income property so much.
A larger example: a $1,200,000 building with $9,500 rent and $300 of laundry income a month, 7% vacancy and $42,000 of expenses has an NOI of about $67,368 and a cap rate of 5.61%. At a 6% market cap rate it would be worth about $1,122,800.
Using cap rates to price a property
Appraisers and commercial brokers often value income property by dividing NOI by the cap rate that similar properties recently sold for. The method works only when the NOI is realistic: sellers sometimes advertise a cap rate based on full occupancy, below-market expenses, or a property tax bill that will rise after the sale. Rebuild the NOI yourself from the rent roll, the actual tax and insurance bills, and your own vacancy and repair assumptions.
Property tax deserves special attention: in many U.S. states the assessed value is reset after a sale, so the tax you will pay may be based on your purchase price rather than the seller's old assessment.
What is a good cap rate?
A higher cap rate means more income per dollar of price, but usually also more risk: an older building, a weaker location, less reliable tenants or a market where rents are not growing. A lower cap rate is typical of newer properties in high-demand areas, where buyers accept less income today in exchange for stability and expected growth. Cap rates also move with interest rates; when borrowing gets more expensive, buyers usually demand higher cap rates. The useful comparison is against recent sales of the same property type in the same area, not a national rule of thumb.
Cap rate versus other returns
- Cash-on-cash return includes your mortgage: it is cash flow after the loan payment divided by the cash you invested. Use the cash-on-cash return calculator.
- Total return or IRR adds loan paydown, appreciation and the sale. The rental property calculator projects those over the years you hold.
- If the cap rate is lower than your mortgage rate, borrowing usually reduces your cash-on-cash return (negative leverage).
Common mistakes
- Subtracting the mortgage payment from NOI. That is cash flow, not NOI.
- Leaving out vacancy, management or reserves because the current owner self-manages and has had no turnover.
- Comparing a cap rate based on this year's NOI with one based on a seller's projected (pro forma) NOI.
- Using the cap rate alone for a single-family home bought mainly for appreciation; for those, total return matters more.
Frequently asked questions
How do you calculate cap rate?
Divide net operating income by the property's value or price. NOI is yearly rent and other income, less vacancy, less operating expenses such as tax, insurance, repairs and management, but not the mortgage.
Does cap rate include the mortgage?
No. The cap rate assumes an all-cash purchase so properties can be compared regardless of financing. Cash-on-cash return is the measure that includes your loan.
How do I value a property from a cap rate?
Divide the NOI by the cap rate that similar properties sell for. For example, $31,600 of NOI at a 6.5% cap rate is worth about $486,154.
Is a higher cap rate better?
It means more income per dollar, but usually comes with more risk or lower expected growth. Compare with recent sales of similar properties in the same market.
Why does a small change in cap rate change the value so much?
Value is NOI divided by the cap rate, so a move from 6.5% to 7.5% lowers the value of the same income by about 13%.
Sources
- Appraisal Institute. The Appraisal of Real Estate, 15th edition (direct capitalization: value = NOI ÷ overall capitalization rate).
- Internal Revenue Service. Publication 527, Residential Rental Property (rental expenses).
Last reviewed 3 November 2026. Results are estimates; see our disclaimer.