Cap Rate Explained: Formula, Good Rates & How to Calculate
Capitalization rate — or cap rate — is the most commonly used metric in commercial and investment real estate. It tells you the unlevered return a property produces based on its income and price. Whether you're comparing rental properties, evaluating a commercial building, or assessing an entire market, cap rate is the starting point for every conversation.
The Cap Rate Formula
Cap Rate = Net Operating Income (NOI) / Property Value (or Purchase Price)
That's it. Two numbers. The result is expressed as a percentage.
Example
- A rental property generates $24,000 in annual NOI (gross rent minus operating expenses, not including mortgage)
- The property costs $300,000
- Cap rate = $24,000 / $300,000 = 8.0%
This means you'd earn an 8% return on your money if you paid all cash and there was no appreciation or depreciation. It's the property's yield, independent of how you finance it.
What NOI Includes (and Doesn't)
Getting the cap rate right depends entirely on calculating NOI correctly:
Included in NOI
- Gross rental income
- Minus vacancy allowance (typically 5-10%)
- Minus property taxes
- Minus insurance
- Minus property management (8-12% of gross rent)
- Minus maintenance and repairs
- Minus HOA fees (if applicable)
- Minus utilities paid by the owner
NOT Included in NOI
- Mortgage payments (principal and interest)
- Capital expenditures (roof replacement, major systems)
- Depreciation
- Income taxes
This separation is intentional — cap rate measures the property's performance independent of how it's financed or the owner's tax situation.
What's a Good Cap Rate?
The answer depends on where the property is and what type it is. Here are typical ranges in 2026:
By Property Type
| Property Type | Typical Cap Rate Range |
|---|---|
| Single-family rental | 5-9% |
| Small multifamily (2-4 units) | 5-8% |
| Large multifamily (5+ units) | 4-7% |
| Office | 6-9% |
| Retail | 5-8% |
| Industrial/warehouse | 5-7% |
| Self-storage | 5-8% |
| Mobile home park | 7-12% |
By Market
| Market Type | Typical Cap Rate |
|---|---|
| Gateway cities (NYC, SF, LA) | 3-5% |
| Major metros (Dallas, Atlanta, Phoenix) | 5-7% |
| Secondary markets (San Antonio, Memphis, Birmingham) | 6-9% |
| Tertiary/rural markets | 8-12% |
The Cap Rate Spectrum
Low cap rates (3-5%) indicate higher prices relative to income — typically in high-demand markets with strong appreciation potential and lower risk. High cap rates (8-12%) indicate lower prices relative to income — typically in riskier markets or with less desirable properties, but with higher current cash flow.
Neither high nor low cap rates are inherently better. A 4% cap rate property in San Francisco might be a better overall investment than a 10% cap rate property in a declining rural market, because the appreciation and tenant quality in San Francisco compensate for the lower current yield.
Three Ways to Use Cap Rate
1. Evaluate a Purchase Price
If you know the property's NOI and the market cap rate, you can determine if the asking price is fair:
- Property NOI: $36,000/year
- Market cap rate for similar properties: 7%
- Fair value: $36,000 / 0.07 = $514,286
- If asking price is $480,000, it's below market (good deal)
- If asking price is $550,000, it's above market (overpriced or seller expects rent growth)
2. Compare Properties
Cap rate lets you compare properties of different sizes and prices on a level playing field. A $200,000 duplex with an 8% cap rate produces a better unlevered return than a $500,000 fourplex with a 6% cap rate, all else being equal.
3. Assess Market Conditions
Tracking cap rates over time tells you whether a market is getting more expensive (compressing cap rates) or more affordable (expanding cap rates). When cap rates compress, it means prices are rising faster than incomes — a sign of a heated market.
Cap Rate Limitations
Ignores Financing
Cap rate assumes an all-cash purchase. It tells you nothing about your actual return when using leverage. A property with a 6% cap rate financed with a 5% mortgage produces a very different return than one financed at 7.5%.
Ignores Appreciation
Some of the best real estate investments have low cap rates but massive appreciation. Cap rate only measures current income yield.
Snapshot in Time
Cap rate uses current NOI and current price. It doesn't account for below-market rents that could be raised, deferred maintenance that will need to be addressed, or upcoming lease expirations that could change income.
Doesn't Work for Flips
Cap rate is irrelevant for fix-and-flip properties because there's no ongoing income stream. Use ARV and the 70% rule instead.
Cap Rate vs. Cash-on-Cash Return
Cash-on-cash return measures your annual cash flow divided by your actual cash invested (including the down payment). It accounts for financing, which cap rate doesn't. Use cap rate for property comparison and valuation; use cash-on-cash for evaluating your personal return with leverage.
Cap Rate Compression and Expansion
Understanding cap rate trends is crucial for market timing:
- Compression (cap rates going down) — prices rising, often driven by low interest rates, strong demand, or institutional capital flooding into a market. Good for sellers, challenging for buyers.
- Expansion (cap rates going up) — prices falling or income not keeping pace. Often triggered by rising interest rates, economic uncertainty, or oversupply. Good for buyers, challenging for sellers.
Since 2022, rising interest rates have caused cap rate expansion in many markets, creating buying opportunities that didn't exist during the ultra-low-rate environment of 2020-2021.
Related Articles
- What Is NOI? Net Operating Income Explained
- NOI: Formula, Calculator & Examples
- IRR: Internal Rate of Return for Real Estate
- Income Approach to Real Estate Valuation