Home›Glossary›Cap Rate

Cap Rate

Investment

Capitalization Rate

A percentage that measures a rental property's annual return based on its net operating income relative to its purchase price or current market value, independent of financing.

Definition

Cap rate (short for capitalization rate) is a percentage that measures the annual return a rental property generates relative to its purchase price or current market value. It is one of the most widely used metrics in commercial and residential real estate investing because it lets investors compare the income-producing potential of different properties on a like-for-like basis, independent of how each is financed.

Because cap rate is calculated before financing costs, it reflects the property's intrinsic earning power rather than a particular buyer's mortgage terms. Investors, appraisers, and lenders all use cap rate to gauge whether a property is fairly priced relative to the income it produces.

Formula

Cap Rate = (Net Operating Income / Current Market Value or Purchase Price) × 100

Where Net Operating Income (NOI) = Gross Rental Income − Operating Expenses (property taxes, insurance, maintenance, property management, vacancy allowance — excluding mortgage payments and depreciation).

Worked Example

You buy a rental property for $400,000. It generates $42,000 in annual gross rent, and operating expenses (taxes, insurance, maintenance, management) total $12,000 per year.

NOI = $42,000 − $12,000 = $30,000

Cap Rate = ($30,000 / $400,000) × 100 = 7.5%

A 7.5% cap rate means the property generates a 7.5% annual return on its purchase price before financing. Use the cap rate calculator to run this on your own numbers, or the rental property ROI calculator to factor in your actual mortgage and leverage.

Key Things to Know

  • Location drives cap rate: Prime, low-risk markets (major coastal US cities) tend to have compressed cap rates of 4-6%, while secondary and tertiary markets often show 8-10%+ to compensate for higher perceived risk.
  • Cap rate is a snapshot, not a total return: It ignores appreciation, tax benefits, and loan paydown — all of which contribute to an investor's total ROI over the holding period.
  • Rising cap rates mean falling prices (all else equal): Since cap rate and value are inversely related for a fixed NOI, an increase in market cap rates (e.g. due to rising interest rates) pushes property valuations down.
  • Compare cap rate to your cost of financing: If your mortgage rate exceeds the property's cap rate, leverage works against you — a concept sometimes called negative leverage.
  • Use IRR for a fuller picture: Cap rate is a single-year snapshot; IRR accounts for the full cash flow timeline including eventual sale, giving a more complete return picture for a real estate investment.

Related Calculators

Cap Rate Calculator →Calculate the capitalization rate for any rental property. Enter property value, gross rent, vacancy, and annual expenses to instantly see NOI and gross yield.
Rental Property ROI Calculator →Analyze rental property returns with cash flow, cap rate, and cash-on-cash ROI. Enter price, mortgage, rent, and expenses to evaluate any US rental deal.

Related Terms

ROIReturn on InvestmentIRRInternal Rate of ReturnMortgageHome Loan Product (US / Global)

Frequently Asked Questions

Cap rates typically range from 4% to 10% depending on market and asset class. Lower cap rates (4-6%) are common in stable, high-demand metros where investors accept lower yield for lower risk, while higher cap rates (8-10%+) usually signal higher risk, weaker markets, or more management-intensive properties.
No. Cap rate is calculated on an all-cash basis using net operating income before financing costs, so it ignores your mortgage interest and principal payments entirely. This makes it useful for comparing properties independent of how each buyer chooses to finance the purchase.
Cap rate measures return based on the full property value, while cash-on-cash return measures return based only on the cash you actually invested (down payment plus closing costs), factoring in your mortgage payments. A leveraged property can have a lower cap rate but a higher cash-on-cash return because financing amplifies returns on the smaller equity outlay.
NOI equals gross rental income minus operating expenses such as property taxes, insurance, maintenance, property management fees, and vacancy allowance — but excluding mortgage payments, depreciation, and capital expenditures. Use the cap rate calculator to plug in your income and expense figures automatically.
Yes, if operating expenses exceed rental income, NOI becomes negative and so does the cap rate. This signals the property is losing money on operations alone, before even accounting for the mortgage, and is a red flag for investors.