What Is Cap Rate?
Capitalization rate (cap rate) measures a property's potential annual return if purchased with all cash. It strips out financing to give you a pure property-level view.
Cap Rate = NOI ÷ Purchase Price × 100
Example: A property with $60,000 NOI purchased for $800,000 has a cap rate of 7.5%.
Step-by-Step Calculation
- Calculate Gross Scheduled Rent (GSR) — all rents if 100% occupied, annualized
- Subtract Vacancy — typically 5–10% depending on market
- Add Other Income — laundry, parking, storage
- Subtract Operating Expenses — taxes, insurance, management (8–10%), maintenance, utilities
- Result = NOI
- Divide NOI by purchase price
Key Rule: Operating expenses do NOT include mortgage payments, depreciation, or capital expenditures. Cap rate is a pre-financing metric.
What Is a Good Cap Rate?
| Market Type | Typical Cap Rate | Risk Level |
|---|---|---|
| Primary (NYC, LA, SF) | 3.5–5% | Lower risk, lower yield |
| Secondary (Phoenix, Denver) | 5–7% | Moderate |
| Tertiary / Value-add | 7–10%+ | Higher risk, higher yield |
Cap Rate vs. Other Metrics
Cap Rate vs. Cash-on-Cash: Cap rate ignores financing; cash-on-cash reflects actual leveraged returns. Use cap rate to compare properties; use CoC to evaluate your specific deal.
Cap Rate vs. GRM: Gross Rent Multiplier is faster to calculate but ignores expenses. Cap rate is more accurate.
Using Cap Rate to Value Property
Property Value = NOI ÷ Market Cap Rate
If comparable properties in the area trade at 6% cap and your property generates $48,000 NOI, its implied value is $800,000. This is how commercial appraisers value income properties.
Common Mistakes
- Using "pro forma" rents instead of current in-place rents
- Including mortgage payments in expenses
- Ignoring management costs (even if self-managing, impute 8–10%)
- Using asking price instead of all-in acquisition cost
Topics:FundamentalsReal Estate InvestingFinance