Real Estate Glossary
What is Cap Rate? Definition, Formula & Examples
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Definition
Cap rate (capitalization rate) is the ratio of a property's annual net operating income (NOI) to its current market value or purchase price, expressed as a percentage. It is the most widely used metric for comparing the income potential of real estate investments independent of financing. A higher cap rate means a higher potential return — but often signals more risk or a less desirable market.
The Cap Rate Formula
Variables explained:
NOI is annual gross rent minus all operating expenses (property tax, insurance, maintenance, management, vacancy) before mortgage payments. Property Value is the purchase price or current market value of the property.
Cap Rate Example with Real Numbers
You purchase a duplex for $300,000. After collecting $28,800 in annual rent and subtracting $8,800 in operating expenses (taxes, insurance, maintenance, management), your NOI is $20,000. Cap Rate = $20,000 / $300,000 × 100 = 6.67%. This means the property yields 6.67 cents of net income for every dollar of value — a solid result in most markets.
Why Cap Rate Matters for Investors
Cap rate lets you compare properties of different sizes and prices on equal footing, without the distortion of loan terms. Lenders, appraisers, and institutional investors all use it to value commercial and multifamily properties. Knowing the prevailing cap rate in a market also lets you quickly estimate what a property should sell for once you know its NOI.
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Frequently Asked Questions
What is a good cap rate for a rental property?
A good cap rate depends on market and risk tolerance. In high-cost coastal cities, 4–5% is common. In Midwest or Sun Belt markets, 6–9% is typical. Anything above 10% usually signals higher risk — such as a lower-quality area or a property needing significant work.
Does cap rate include the mortgage?
No. Cap rate intentionally excludes financing costs so you can compare properties regardless of how they are financed. To measure returns after your specific mortgage, use cash-on-cash return instead.
Can cap rate be negative?
Technically yes, if operating expenses exceed gross income. This happens with high-vacancy properties or those with very high tax/maintenance burdens. A negative cap rate means the property loses money before even paying the mortgage.
How does cap rate relate to property value?
They move inversely. If market cap rates rise (say from 5% to 6%), property values fall for the same income. If cap rates compress (fall), values rise. This is why institutional investors watch cap rate trends closely.
Related Terms
NOI (Net Operating Income)
Net Operating Income (NOI) is the annual income a property generates after all operating e…
Cash-on-Cash Return
Cash-on-cash return is the ratio of a property's annual pre-tax cash flow to the total cas…
Cap Rate Formula
The cap rate formula calculates a property's capitalization rate by dividing its annual ne…
Gross Rent Multiplier (GRM)
The Gross Rent Multiplier (GRM) is a quick valuation metric that divides a property's purc…
Capitalization (in Real Estate)
In real estate, capitalization (or "capping") refers to the process of converting a proper…