The capitalization rate, or cap rate, is a quick way to compare the income a property produces with what it costs. It equals the property’s net operating income divided by its purchase price or current market value, expressed as a percentage.
Think of it as the unleveraged annual return you would earn if you bought the property with all cash. Because it ignores financing, it lets you compare buildings on equal footing.
How to calculate it
Cap rate = Net operating income / Property value
You can rearrange the formula to estimate value:
Property value = Net operating income / Cap rate
Worked example
Suppose a hypothetical fourplex is listed at $900,000. Each unit rents for $2,000 a month, so gross potential rent is $96,000 a year. After a 5% vacancy allowance ($4,800) and $34,000 in operating expenses, the NOI is $57,200.
$57,200 divided by $900,000 equals 0.0636, or a cap rate of about 6.4%.
Now flip it. If similar fourplexes nearby trade at a 7% cap rate, the same NOI implies a value of $57,200 divided by 0.07, or about $817,000. That gap is a useful starting point for negotiation.
Why it matters for landlords
- Comparing deals. Cap rates let you line up properties of different sizes and prices and see which produces more income per dollar.
- Reading the market. Cap rates in an area tend to move with interest rates and investor demand. Falling cap rates mean buyers are paying more for each dollar of income.
- Planning upgrades. Because value equals NOI divided by the cap rate, raising NOI by $5,000 at a 6% cap rate adds roughly $83,000 in value.
A cap rate is only as good as the NOI behind it. Sellers sometimes show pro forma numbers with optimistic rents and thin expenses, so ask for actual operating statements and a rent roll. Keeping your own books current in TenantLoop accounting makes your numbers easy to verify when it is your turn to sell.
Related terms
Related questions.
Is a higher cap rate better?
It depends on your goals. A higher cap rate means more income per dollar of price, but it often signals more risk, an older building or a weaker location. A lower cap rate usually points to a stable, in-demand asset.
Does the cap rate account for my mortgage?
No. The cap rate uses NOI, which is calculated before debt service. To measure the return on the cash you actually put in, use cash-on-cash return.
Can I use the cap rate to value a single-family rental?
You can, but appraisers usually rely on comparable sales for single-family homes. Cap rates are most useful for multifamily and commercial properties bought mainly for income.