Cap Rate (Capitalization Rate)

The capitalization rate usually called the cap rate is a simple metric that compares a property’s annual income to its price. It’s one of the fastest ways to estimate a property’s yield and to compare investment opportunities without getting bogged down by financing differences. At its core, the cap rate answers the question: If I bought this property with cash, what percentage of the purchase price would I collect in net operating income each year?

The formula

Cap Rate (%) = (Annual Net Operating Income / Property Value) × 100

Where:

• Annual Net Operating Income (NOI) = effective gross income after vacancy losses minus operating expenses.
• Property Value can be the current market price, the asking price, or a target selling price.

What counts as income and expense

• Gross rental income: total rent you expect to collect in a year before vacancy and expenses.
• Vacancy losses: the percentage of time the property is empty multiplied by gross income (we subtract this to get effective gross income).
• Operating expenses: recurring costs to run the property insurance, repairs, utilities you pay, property management fees, landscaping, licensing, etc. Operating expenses do not include mortgage principal & interest, depreciation, or income taxes; those belong to the investor’s financing and tax situation, not the property’s operating performance.

How this calculator works

1. Enter the Property value (the price or market value).
2. Enter the Annual gross income (total yearly rent).
3. Enter the Operating expenses (%) or supply your expense total and convert to percentage of gross income.
4. Enter Vacancy rate (%) to estimate income lost to vacancy.
5. The calculator computes:
   • Operating expenses (total) = gross income × expenses%.
   • Effective gross income = gross income × (1 − vacancy%).
   • Annual net income (NOI) = effective gross income − operating expenses, or equivalently effective gross income × (1 − expenses%).
   • Cap rate (%) = (NOI / property value) × 100.

How investors use cap rate

• Quick comparison: Cap rate lets you rank properties by income return while stripping out differences in financing structures. A higher cap rate normally indicates higher income return but often also higher perceived risk.
• Valuation from market cap rates: If you know the market cap rate for comparable properties, you can estimate value by dividing NOI by the market cap rate: Estimated value = NOI / Market cap rate. That’s commonly used by buyers and brokers to check asking prices.
• Sensitivity analysis: Change vacancy, expense percentages, or rents to see how NOI and value react.

What is a “good” cap rate

There’s no universal “good” number. Cap rates differ by location, asset type (single-family vs. multifamily vs. retail), property condition, and local interest-rate environment. Urban, low-risk areas often trade at lower cap rates (lower yield, assumed lower risk); secondary or tertiary markets often have higher cap rates to compensate for added risk. Use local comparables and recent sales to judge what’s realistic.

How cap rate interacts with interest rates and market trends

Cap rates tend to move with broader capital market conditions: when interest rates rise, buyers demand higher yields and cap rates usually increase (reducing valuations), and when rates fall, cap rates compress. That said, cap rate movement is not one-to-one with interest rates because demand, supply, and expectations about rent growth also matter. Use cap rates alongside other metrics (cash-on-cash return, IRR, debt coverage ratio) for a full picture.

Limitations & common pitfalls

• Cap rate ignores financing – it’s a pre-debt measure. Two buyers using different loan terms can get very different cash returns from the same cap rate.
• Cap rate is static – it captures a snapshot (current NOI vs price) and doesn’t reflect future rent growth, capital expenditures, or tax changes. For those you need multi-year models (cash flow projections, IRR).
• Comparability problems – comparing cap rates only makes sense when properties are similar in type, location, and condition. Don’t compare a gut-rehab opportunity to a stabilized core asset using cap rate alone.
• Data quality – inaccurate estimates for vacancy or expenses will distort the cap rate; always use conservative assumptions or sensitivity ranges.

Practical tips

• Use actual expense line-items when available rather than generic percent assumptions.
• Run several scenarios (best-case, base, worst-case) for vacancy and expenses.
• Cross-check cap-rate valuations with sales comparables and with a discounted cash flow if you expect significant rent growth or capital expenditures.
• Remember to adjust NOI for one-time items (large repairs, unusual income) to reflect normalized operating performance.

FAQs

Q1. Does cap rate include mortgage payments?

A: No. Cap rate uses NOI, which is income before debt service. Mortgage effects are examined separately with cash-on-cash return or debt service coverage ratios.

Q2. Can cap rate determine exact property value?

A: It provides an estimate. Valuation from cap rate is a useful rule of thumb (Value = NOI / cap rate) but should be confirmed with market comps, appraisals, and cash-flow modeling.

Q3. Should I prefer higher or lower cap rates?

A: Higher cap rates mean higher immediate income yield but often reflect higher risk or lower growth expectations. Low cap rates usually indicate lower risk and/or higher competition for the asset. Balance yield against risk and your investment horizon.

Q4. What’s the difference between cap rate and ROI?

A: Cap rate uses NOI and property value (pre-debt), giving a property-level yield. ROI (or cash-on-cash return) accounts for your personal cash invested and financing, so it reflects investor-level return.

Sources: Omni Calculator, Commercial Real Estate Loans, Mynd Property Management, RentSpree, Commercial Loan Direct, and Tilt Analytics.