Cap rate is the standard shorthand for what an income property yields. It strips financing out of the picture entirely, which makes it useful for comparing two buildings and useless for telling you what you will actually earn after a mortgage. Understanding both halves of that sentence is most of what there is to know.
The formula
Cap Rate = Net Operating Income ÷ Property Value. A property producing $57,200 of NOI priced at $780,000 carries a 7.3% cap rate. Rearranged, it also values a property: at a market cap rate of 6.5%, that same $57,200 of NOI implies a value of roughly $880,000. That second form is how commercial appraisal works and why raising NOI raises value.
What a cap rate is actually telling you
It is the unlevered annual return at that price — what you would earn paying all cash, before financing and before tax. Low cap rates signal markets where buyers accept less current yield in exchange for appreciation, stability, or both. High cap rates signal the reverse: more yield, and more of whatever risk is producing it. A 9% cap in a shrinking rust-belt submarket and a 4.5% cap in coastal California are both rational prices for very different bets.
The mistake: the NOI underneath is doing all the work
Cap rate is arithmetic, so it inherits every flaw in the NOI it was built from. A seller who omits property management because they self-manage, excludes capital reserves, and assumes zero vacancy can manufacture a cap rate a full point or two above reality. Always rebuild the NOI yourself before believing a cap rate. Ask whether it is trailing or pro forma. In practice the quality of the NOI matters more than the cap rate quoted on it.
Where cap rate breaks down
It is a poor fit for single-family rentals, which are priced off comparable sales rather than income — a single-family cap rate is a number you can calculate but the market does not use. It ignores financing completely, so two investors buying the same building at the same cap rate can have wildly different returns. And it is a single-year snapshot that says nothing about rent growth, lease rollover or capital needs three years out.
Cap rate and leverage
When your borrowing rate sits below the cap rate, leverage amplifies returns — positive leverage. When it sits above, leverage works against you, and it is entirely possible to buy a property at a respectable cap rate and lose money monthly. This is the arithmetic that has caught a lot of investors since rates moved: a 6% cap financed at 7.5% is negative leverage no matter how good the building is. Run the payment before the cap rate — the cap rate calculator and the cash flow calculator together give the real picture.
Capitalization Rate (Cap Rate) FAQ
It depends entirely on market and asset class. Higher cap rates mean more current yield and usually more risk; lower ones mean the opposite. Compare only against genuinely similar properties in the same submarket.
Purchase price when evaluating a deal you are buying; current market value when assessing a property you already own. Using an outdated basis on a long-held property produces a flattering and meaningless number.
No. Cap rate is unlevered by definition. Cash-on-cash return is the metric that accounts for financing.
Because buyers price against the cost of capital and against alternative yields. When borrowing costs rise, buyers demand more yield, which means paying less for the same NOI — cap rates expand and values fall.
Limited use. Single-family homes are valued on comparable sales, not income, so the cap rate you calculate will not be what the market prices off. Cash-on-cash and DSCR are more relevant.
Dividing NOI by a target cap rate to derive value — the same formula rearranged. It is how commercial appraisers apply the income approach and how you estimate what improving NOI does to your equity.