Cap Rate

How cap rate works

The formula is deliberately simple:

Cap Rate = Net Operating Income ÷ Property Value

Net operating income is rental income minus operating expenses — taxes, insurance, management, maintenance, utilities, reserves. It does not subtract your mortgage payment. That exclusion is the whole point: cap rate describes the property, not your financing. Two buyers with completely different loans looking at the same building calculate the same cap rate.

Because the formula has three variables, you can rearrange it. If you know the NOI and the cap rate the market is paying, you get a value: Value = NOI ÷ Cap Rate. This is how most commercial property is actually priced.

Worked example

A 12-unit apartment building listed at $2,400,000:

• Gross rental income — $264,000
• Vacancy allowance (6%) — −$15,840
• Effective gross income — $248,160
• Operating expenses (taxes, insurance, management, maintenance, reserves) — −$68,160
• Net operating income — $180,000

$180,000 ÷ $2,400,000 = 7.5% cap rate. You can run your own figures through the cap rate calculator.

Now watch what a $500/month rent increase per unit does. Twelve units × $500 × 12 months = $72,000 more NOI, so NOI becomes $252,000. At the same 7.5% market cap rate, the building is now worth $252,000 ÷ 0.075 = $3,360,000. A $72,000 income gain created roughly $960,000 of value. This multiplier effect is the entire logic behind value-add commercial real estate.

What it means for you

A low cap rate is not automatically a bad deal, and a high cap rate is not automatically a good one. Cap rate is a risk price. Low cap rates cluster around stable assets in strong markets — reliable income, so buyers accept a lower return. High cap rates cluster around older buildings, weaker submarkets, shorter leases, or property types investors consider volatile. A 9% cap rate is the market telling you it sees risk.

For financing, the number that matters most is the relationship between the cap rate and your loan constant — your annual debt service divided by the loan amount. If the cap rate is above the loan constant, the property produces more income than the debt costs and leverage works in your favor (positive leverage). If it is below, borrowing more actively reduces your cash-on-cash return. When you want to see where a real quote lands against the cap rate you are underwriting, start a commercial real estate loan application and compare the two side by side.

What to watch for

• Ask whose NOI it is. Listings frequently quote a cap rate on pro forma NOI — projected rents after improvements that have not happened yet. Always recalculate on trailing twelve-month actuals from the T-12 and the rent roll.
• Check whether expenses are complete. Omitting management fees (because the owner self-manages) or replacement reserves inflates NOI and makes the cap rate look better than it is. Add back a market management fee of roughly 3–5% and a reserve allowance before you compare anything.
• Cap rates move with interest rates. When Treasury yields rise, cap rates generally follow. A property bought at a 5% cap in a 6% cap market has lost value even if its income never changed.
• Cap rate ignores your loan entirely. It says nothing about your actual return. For that you need cash-on-cash return, which does account for debt service — and it is the number that decides whether an investment property loan makes the deal work or breaks it.

What is a good cap rate?

It depends entirely on property type and market. Stabilized multifamily in a major metro may trade at 4.5–5.5%; suburban retail or older industrial often lands at 6.5–8%; hospitality and specialty assets trade higher still. "Good" means appropriate for the risk you are taking, not simply high.

Is a higher cap rate better?

Higher cap rate means more income per dollar invested — and more risk. Investors seeking stability accept lower cap rates for reliable tenants and strong locations. Investors seeking yield take higher cap rates and accept vacancy, capital expenditure, and market risk alongside it.

What is the difference between cap rate and cash-on-cash return?

Cap rate assumes an all-cash purchase and ignores financing. Cash-on-cash return divides your annual pre-tax cash flow after debt service by the actual cash you invested. With leverage, the two numbers can diverge sharply — which is exactly why lenders look at both.