The capitalization rate — universally shortened to cap rate — is the single most used metric in real estate investing. It tells you the unlevered yield a property generates relative to its market value, letting you compare very different properties on a common basis.
The Formula
Cap Rate = Net Operating Income (NOI) ÷ Property Value
Where NOI = Gross Rental Income − Vacancy − Operating Expenses (property tax, insurance, maintenance, property management, utilities). NOI explicitly excludes mortgage payments — cap rate is a pre-financing metric.
Example: A property priced at $800,000 generates $52,000 in annual NOI. Cap rate = 52,000 ÷ 800,000 = 6.5%.
What Makes a "Good" Cap Rate?
There is no universal threshold — cap rates vary dramatically by:
- Market — A 3.5% cap rate is common in Vancouver or San Francisco; 7–9% is typical in secondary markets like Winnipeg, St. Louis, or Memphis.
- Asset class — Multi-family residential typically trades at lower cap rates (tighter) than commercial retail or industrial. Single-family is often valued on comparables rather than cap rate.
- Risk profile — A fully stabilized, long-tenanted property commands a tighter cap rate than a value-add play with near-term vacancy.
As a starting rule of thumb: compare properties within the same market and asset class. A lower cap rate means you're paying more per dollar of income (like a lower P/E on a stock); a higher cap rate means more income per dollar but usually reflects more risk.
Cap Rate vs Cash-on-Cash Return
Cap rate ignores your financing. Cash-on-cash return measures the actual yield on your invested equity after mortgage payments. In a leveraged purchase:
- If your mortgage rate is below the cap rate, leverage amplifies returns — positive leverage.
- If your mortgage rate is above the cap rate, leverage destroys returns — negative leverage. This was common in 2023–2024 as cap rates compressed while interest rates rose.
Using Cap Rate to Value a Property
You can also invert the formula to estimate value from income: Value = NOI ÷ Cap Rate. If comparable properties in the area sell at a 6% cap and your target property has $48,000 NOI, the market-implied value is $48,000 ÷ 0.06 = $800,000. This is how appraisers and brokers value income-producing properties.
Key Limitations
- Garbage in, garbage out — Cap rate is only as reliable as your NOI estimate. Sellers often present pro-forma NOI based on fully-rented assumptions; always underwrite with current in-place income and conservative vacancy.
- Ignores appreciation — A 4% cap rate in a high-growth market may outperform a 7% cap rate in a stagnant one over a 10-year hold when total return is considered.
- Poor for single-family — SFH is typically valued on comparables, not income. Using cap rate on SFH gives misleading results.
- Point-in-time snapshot — A cap rate reflects today's NOI. For value-add plays, model the stabilized NOI to get the going-in vs stabilized cap rate.
Calculate Yours
Use our Cap Rate Calculator to compute NOI, cap rate, and implied property value from your inputs. For a full picture, pair it with the Cash Flow Calculator and Cash-on-Cash Return Calculator.