If you're evaluating rental properties, you've probably come across the term "cap rate." It's one of the most commonly used metrics in real estate investing—and for good reason. Cap rate gives you a quick snapshot of a property's potential return, making it easier to compare different investment opportunities.

In this guide, we'll break down exactly what cap rate means, how to calculate it, and how to use it when analyzing deals.

What is Cap Rate?

Cap rate (short for capitalization rate) measures the expected rate of return on a real estate investment property. It shows the relationship between a property's net operating income (NOI) and its current market value or purchase price.

Think of it as the answer to the question: "If I bought this property with cash, what annual return would I get from the rental income?"

A property with a 6% cap rate, for example, would generate roughly 6% of its purchase price in net operating income each year.

The Cap Rate Formula

The formula is straightforward:

Cap Rate = Net Operating Income (NOI) ÷ Property Value × 100

Where:

• Net Operating Income (NOI) = Annual rental income minus operating expenses (not including mortgage payments)
• Property Value = The purchase price or current market value

Example Calculation

Let's say you're looking at a rental property listed at $500,000. It generates $60,000 in annual rent and has $18,000 in operating expenses (property taxes, insurance, maintenance, property management, etc.).

Step 1: Calculate NOI

$60,000 (rent) - $18,000 (expenses) = $42,000 NOI

Step 2: Calculate Cap Rate

$42,000 ÷ $500,000 × 100 = 8.4% cap rate

This means the property would return 8.4% annually on a cash purchase, before financing costs.

What's a Good Cap Rate?

There's no universal "good" cap rate—it depends on property type, location, and market conditions. Here's a general framework:

Cap Rates by Property Type (2024-2025 Averages)

The Risk-Return Tradeoff

Cap rates reflect risk. Here's the general pattern:

• Lower cap rates (3-5%): Typically found in prime locations, newer properties, or stable asset classes. Lower risk, lower returns, higher prices.
• Mid-range cap rates (5-7%): Balanced risk/return profile. Common for Class B properties in secondary markets.
• Higher cap rates (7%+): Often indicate higher risk—older properties, less desirable locations, or distressed assets. Higher potential returns but more uncertainty.

A 10% cap rate might look attractive on paper, but ask yourself: why is the market pricing this property to yield 10% when similar properties yield 6%? There's usually a reason.

What Cap Rate Doesn't Tell You

Cap rate is useful for quick comparisons, but it has limitations:

1. Ignores financing: Cap rate assumes an all-cash purchase. It doesn't account for mortgage payments, which significantly impact your actual returns.

2. Snapshot in time: It's based on current income and expenses. Future rent increases, vacancy changes, or capital expenditures aren't factored in.

3. Doesn't include appreciation: Real estate returns come from both income and property value growth. Cap rate only measures the income side.

4. Operating expense assumptions vary: Two investors might calculate different cap rates for the same property based on how they estimate expenses.

For a more complete picture, you'll want to also look at cash-on-cash return (which factors in financing) and IRR (which accounts for appreciation and the full holding period).

How to Use Cap Rate When Evaluating Deals

1. Compare Similar Properties

Cap rate is most useful when comparing properties of the same type in the same market. Comparing a Class A apartment building's cap rate to a rural office building's cap rate isn't meaningful—the risk profiles are completely different.

2. Estimate Property Value

You can rearrange the formula to estimate what a property should be worth:

Property Value = NOI ÷ Cap Rate

If a property generates $50,000 in NOI and similar properties trade at a 6% cap rate, the estimated value would be:

$50,000 ÷ 0.06 = $833,333

3. Identify Market Trends

Falling cap rates indicate rising prices (buyers willing to accept lower returns). Rising cap rates suggest falling prices or increased risk perception. Tracking cap rate trends helps you understand where you are in the market cycle.

4. Screen Deals Quickly

Before diving into detailed analysis, cap rate helps you quickly filter properties. If your minimum acceptable cap rate is 6% and a property pencils out at 4%, you can move on without spending hours on due diligence.

Cap Rate vs. Other Metrics

Each metric answers a different question. Smart investors use multiple metrics together rather than relying on any single number.

Key Takeaways

• Cap rate = NOI ÷ Property Value, expressed as a percentage
• It measures the unleveraged return on a real estate investment
• Higher cap rates generally indicate higher risk (and potentially higher returns)
• Average cap rates vary by property type, location, and market conditions
• Use cap rate alongside other metrics like cash-on-cash return for complete analysis
• Cap rate is best for comparing similar properties in the same market

Understanding cap rate is foundational to real estate investing. While it's not the only metric that matters, it's often the first one investors look at—and knowing how to interpret it will help you make better investment decisions.