Comprehensive Guide
Learn more in our Investing Guide.
How it works
The cap rate divides net operating income — rent minus operating expenses, before any mortgage — by the property's price. It is the yield a fully cash buyer receives, and because it excludes financing, it is the standard metric for comparing properties and markets directly. Cap rates carry a market with them: a 4% cap in a prime city reflects low risk and heavy competition for assets; a 9% cap in a secondary market prices in vacancy, tenant quality and slower appreciation. The cap rate also moves with interest rates — when bonds pay more, buyers demand higher caps, and prices fall. The engine computes the ratio and its inverse: a target cap rate tells you what price you can pay for a given NOI, which is the deal-structuring use of the number. It does not measure cash flow after debt — that is the cash-on-cash return's job — so use them as a pair.Formula
Cap rate = NOI / price x 100 | Price = NOI / target cap rate
Tips
- Higher cap = higher risk and higher return; compare only within similar property types and markets.
- Re-run the price side: what NOI does your target cap allow at the asking price?
- Cap rates compress when rates fall and expand when they rise — track the direction before buying.
- A lender's appraisal is basically an NOI and cap rate conversation — understand both before meeting them.
Frequently asked questions
What is a good cap rate?
For residential rentals, 5-7% is typical; commercial properties range from 4% (prime, low risk) to 10%+ (secondary, higher risk). The 'good' cap rate is the one that compensates for the risk — comparing a 9% cap in a weak market to a 5% cap in a strong one requires the risk conversation, not the number.
How is cap rate different from cash-on-cash return?
Cap rate ignores financing entirely — it is NOI over price, as if all-cash. Cash-on-cash divides after-debt cash flow by the cash you actually invested, so leverage changes it dramatically. The cap rate compares deals; cash-on-cash compares your invested dollars.
Do I include mortgage payments in NOI?
No — NOI is rent minus operating expenses before debt service. Interest belongs to the cash-flow analysis, and the cap rate exists specifically to be financing-agnostic.
What moves cap rates?
Interest rates (higher rates push caps up, prices down), market risk perception, vacancy trends, and demand for income assets. Watching the cap-rate trend in a market is watching its pricing temperature.