Cap Rate Explained

Cap rate is the ratio of a property's annual net operating income (NOI) to its purchase price or current market value. A property generating $28,000 in NOI valued at $400,000 has a 7% cap rate. In plain English: if you paid cash for the property, you'd earn a 7% annual return from rental income alone, before financing costs and tax benefits.

The formula is simple — NOI ÷ Property Value = Cap Rate — but the inputs require honesty. NOI is gross rental income minus operating expenses (taxes, insurance, maintenance, management, vacancy reserve), but it excludes mortgage payments and capital expenditures. Getting NOI right is the difference between an accurate analysis and an expensive mistake.

What Cap Rate Tells You (and What It Doesn't)

Cap rate serves two purposes: comparing properties on an apples-to-apples basis, and determining whether a property is fairly priced. Because it strips out financing, you can compare a property you'd buy with cash to one you'd finance heavily. A 7% cap rate property is a 7% cap rate property regardless of your loan terms.

What cap rate doesn't tell you is the total return. It ignores appreciation, tax benefits, mortgage paydown, and the effect of leverage. A 5% cap rate property in a market appreciating 4% annually delivers a very different total return than a 5% cap rate property in a flat or declining market. Cap rate is one input, not the whole story.

What's a "Good" Cap Rate?

It depends entirely on the market and property type. In major metros like New York, San Francisco, or Miami, cap rates of 3-5% are common for multifamily properties — investors accept lower yields in exchange for appreciation potential and stability. In secondary markets, 6-8% is typical. In rural or higher-risk areas, 8-12% cap rates reflect the additional risk and lower appreciation expectations.

Higher cap rate doesn't automatically mean better investment. A 10% cap rate often signals higher risk — tenant quality, deferred maintenance, declining neighborhood, or difficulty finding quality management. Meanwhile, a 4% cap rate in a prime location might outperform over 10 years when appreciation is factored in. Context matters enormously.

Using Cap Rate to Find Fair Value

Cap rate works in reverse too. If you know the typical cap rate for properties in a market (say, 6.5%) and you know a property's NOI ($26,000), you can calculate what a buyer should pay: NOI ÷ Target Cap Rate = Fair Value. That's $26,000 ÷ 0.065 = $400,000. If the seller is asking $450,000, you know you'd be buying at a below-market return — a 5.8% cap rate — and can negotiate accordingly.

This reverse calculation is how experienced investors quickly assess whether a listing is worth pursuing. If the asking price implies a cap rate well below market norms and there's no obvious reason for the premium (exceptional location, below-market rents with upside, brand-new construction), the property is likely overpriced.