The formula and a worked example
Cap rate is calculated as annual net operating income (NOI) divided by the property's current market value or purchase price, multiplied by 100. NOI itself is gross rental and other income minus operating expenses and vacancy loss — critically, before any mortgage payment or income taxes are subtracted, which is what makes cap rate an unlevered, financing-independent measure.
Worked example: a property generating $24,000 in annual NOI and valued at $400,000 has a cap rate of 6% ($24,000 ÷ $400,000 × 100), equivalent to $2,000 in monthly NOI. Because financing costs are excluded, this 6% figure holds whether the property was bought entirely in cash or with a large mortgage — only the NOI and the value matter to the calculation.
- Cap rate = (annual NOI ÷ property value) × 100
- Monthly NOI = annual NOI ÷ 12
Reference ranges — not a rule
General ranges are commonly discussed in real estate investment analysis, but actual acceptable cap rates vary substantially by property type, market, and the prevailing interest-rate environment at the time of purchase.
| Approximate cap rate range | General characterization |
|---|---|
| Below 4% | Low — often prime, low-risk locations or markets with high appreciation expectations |
| 4% – 7% | Moderate — a commonly cited range for stabilized income properties |
| 7% – 10% | Higher — often higher perceived risk, secondary markets, or heavier management needs |
| Above 10% | High — commonly distressed properties or markets with limited appreciation expectations |
Why a higher cap rate isn't automatically better
A higher cap rate can reflect a genuinely better income return relative to price, but it can equally reflect higher risk, a less desirable location, deferred maintenance, or a property that will require more active management — cap rate alone does not distinguish between these explanations. Treating a high cap rate as automatically a better investment without investigating why it is elevated is one of the most common mistakes in using this metric.
Cap rate is also a point-in-time snapshot based on current or trailing NOI. It does not project future rent growth, expense changes, or appreciation, all of which materially affect an investment's actual long-run return — it is a screening tool, not a full underwriting model.
Cap rate vs. cash-on-cash return
Cap rate and cash-on-cash return answer different questions and should not be used interchangeably. Cap rate measures NOI as a percentage of the full property value, excluding any financing, so it reflects the property's unlevered performance and is useful for comparing properties regardless of how each is financed. Cash-on-cash return instead measures actual annual cash flow after the mortgage payment as a percentage of the cash actually invested — typically the down payment — so it reflects the levered, investor-specific return, which can be higher or lower than the cap rate depending on the financing terms used.
Preguntas frecuentes
What is a good cap rate for a rental property?
There is no universal 'good' cap rate — it depends heavily on property type, market and the interest-rate environment. Roughly 4-10% is commonly discussed across various markets and property types, with lower cap rates often associated with prime, lower-risk locations and higher cap rates with higher perceived risk or secondary markets.
How is cap rate calculated?
Cap rate equals annual net operating income (NOI) divided by the property's current value or purchase price, expressed as a percentage. A property with $24,000 in annual NOI valued at $400,000 has a 6% cap rate ($24,000 ÷ $400,000 × 100).
Does cap rate include the mortgage payment?
No. Cap rate uses net operating income (NOI), which by definition excludes debt service (mortgage principal and interest) and income taxes. This is what makes it useful for comparing properties regardless of how each is financed.
What's the difference between cap rate and cash-on-cash return?
Cap rate measures NOI against the full property value with no financing involved. Cash-on-cash return measures actual cash flow after the mortgage payment against the cash actually invested (usually the down payment) — the levered, investor-specific return, which financing terms can push higher or lower than the cap rate.
Why do cap rates vary so much by location?
Cap rates reflect the market's collective assessment of a property's risk and growth prospects relative to its income. Prime, low-risk markets with strong appreciation expectations tend to trade at lower cap rates, while higher-risk or slower-growth markets tend to trade at higher cap rates to compensate investors for that added risk.
Referencias
- Fannie Mae Multifamily — underwriting guidance on net operating income and capitalization rate definitions. https://www.fanniemae.com/
- Appraisal Institute. The Appraisal of Real Estate. 15th ed. Appraisal Institute, 2020.
- Federal Reserve Board — commercial real estate lending guidance. https://www.federalreserve.gov/