How Do You Calculate Cap Rate?
Cap rate equals net operating income (NOI) divided by the property's value or purchase price. NOI is gross rental income minus all operating expenses (taxes, insurance, maintenance, management) excluding mortgage payments. If a property earns $18,000 NOI and costs $250,000, the cap rate is 7.2%. Cap rate is financing-independent — two identical properties have the same cap rate regardless of how they're financed.
What Is a Good Cap Rate?
Cap rates vary significantly by market and property type. In high-demand urban markets, cap rates of 3% to 5% are common because appreciation expectations are high. In secondary and tertiary markets with less appreciation potential, investors demand 6% to 10% cap rates to compensate for risk. There's no universal 'good' cap rate — context matters. Compare to local market rates and alternative investments.
What Are the Limitations of Cap Rate?
Cap rate doesn't account for financing, so it can't tell you your actual cash return if you use a mortgage. It also ignores future appreciation, which is often a major driver of returns in gateway markets. Cap rates work best for comparing similar properties in the same market. Using cap rate across different property types or markets without adjustment can lead to misleading conclusions.
Frequently asked questions
Is a higher or lower cap rate better?
It depends on your goals. Higher cap rates offer more current income but often come with more risk or less appreciation potential. Lower cap rates typically reflect safer markets or properties where investors expect strong appreciation. Neither is universally better — alignment with your investment strategy matters most.
How is cap rate different from cash-on-cash return?
Cap rate ignores financing and measures return on total property value. Cash-on-cash return measures the actual cash income on the cash you invested, including the effect of mortgage financing. A leveraged investment can have a much higher cash-on-cash return than its cap rate.