How to Calculate Cap Rate: The Investor's Essential Metric
Cap rate is the single most important metric for evaluating rental and commercial investment properties. It tells you the rate of return you would earn if you bought the property with all cash, making it the universal comparison tool across different properties, markets, and price points.
The cap rate formula
Cap Rate = Net Operating Income (NOI) / Property Value
NOI is annual gross income minus operating expenses (but NOT mortgage payments). Property value is the purchase price or current market value.
Calculating NOI
NOI = Gross Rental Income - Vacancy Loss - Operating Expenses. Operating expenses include property taxes, insurance, maintenance, management, and reserves. They do NOT include mortgage payments, depreciation, or capital expenditures. A detailed rental analysis walkthrough is in our rental property analysis guide.
What is a good cap rate
| Cap Rate Range | Property Type | Risk Level |
|---|---|---|
| 3-5% | A-class properties in prime locations | Low risk, low return |
| 5-7% | B-class properties in solid neighborhoods | Moderate risk, moderate return |
| 7-10% | C-class properties, value-add opportunities | Higher risk, higher return |
| 10%+ | D-class or distressed properties | Highest risk |
Using cap rate to compare properties
Cap rate normalizes the comparison. A $200K property generating $16K NOI (8% cap) is producing a better unleveraged return than a $400K property generating $24K NOI (6% cap), even though the second property has higher absolute income.
Using cap rate to value properties
Property Value = NOI / Cap Rate
If you know the NOI ($30K) and the market cap rate for similar properties (7%), the property is worth approximately $428,571. This income approach to valuation is standard for commercial properties and multifamily with 5+ units.
Cap rate limitations
- Does not account for financing (use cash-on-cash return for leveraged analysis)
- Does not account for appreciation potential
- Does not account for capital expenditures (deferred maintenance can make a high cap rate deceptive)
- Varies by market — a 6% cap in San Francisco is excellent; in Detroit it is mediocre
Cap rate vs cash-on-cash return
Cap rate assumes an all-cash purchase. Cash-on-cash return measures your return on actual cash invested (after leverage). A property with a 7% cap rate might produce a 12% cash-on-cash return with 75% leverage because your actual cash invested is only 25% of the purchase price.
Related guides
- Cap Rate Explained (Deep Dive)
- How to Analyze a Rental Property
- How to Calculate Rental Yield
- How to Calculate ROI on Rentals
- Rental Cash Flow Analysis