Cap rate (capitalization rate) is the annual return a rental property produces from its operations, before any financing, as a percentage of its price or value. It’s the quickest way to compare income properties: a higher cap rate means more income per dollar of value. This guide covers the cap rate formula, how to calculate cap rate on a rental property, and how lenders and investors use it.
Cap Rate Meaning in Plain English
If you bought a property with all cash, the cap rate is roughly the yearly return you’d earn from rents after operating expenses. Because it ignores the loan, it lets you compare a duplex in Orlando with a 6-unit building in Ohio on equal terms.
The Cap Rate Formula
Cap rate = Net operating income (NOI) ÷ Property value or purchase price
Net operating income (NOI) = gross rental income − vacancy − operating expenses (taxes, insurance, repairs, management, utilities you pay, HOA). NOI does not include mortgage payments or capital improvements.
How to Calculate Cap Rate on a Rental Property
Example: a 6-unit building listed at $800,000
- Gross rent: 6 units × $1,200 × 12 = $86,400
- Less 5% vacancy: −$4,320 → $82,080
- Less operating expenses (taxes, insurance, repairs, management): −$28,000
- NOI = $54,080
- Cap rate = $54,080 ÷ $800,000 = 6.76%
For a single family rental the steps are the same: one unit’s rent, less vacancy and expenses, divided by the price.
What Is a Good Cap Rate?
There’s no single “good” number. Cap rates move with:
- Location and demand. Prime markets usually trade at lower cap rates.
- Property condition and class. Older properties needing work often show higher cap rates and higher risk.
- Interest rates. When borrowing costs rise, investors usually want higher cap rates.
Compare a property’s cap rate with recent sales of similar properties in the same area, not with a national rule of thumb.
Cap Rate vs. DSCR vs. Cash-on-Cash Return
| Metric | What it measures | Includes financing? |
|---|---|---|
| Cap rate | NOI ÷ value | No |
| DSCR | Rent or NOI ÷ loan payment | Yes. Lenders use it to size loans |
| Cash-on-cash return | Annual cash flow ÷ cash invested | Yes |
A property can have a solid cap rate and still fail a lender’s DSCR test if the loan payment is too high. Our DSCR loans require at least 1.20x, and multifamily term loans are sized on the building’s cash flow.
Using Cap Rate on Value-Add Deals
On a renovation, compare today’s cap rate with the stabilized cap rate after you raise rents. That increase in NOI is what creates value, and it’s how multifamily bridge loans are sized, at up to 75% of stabilized value. More terms are in our real estate investing glossary.
Cap Rate FAQs
What is cap rate in real estate?
Cap rate is a property’s net operating income divided by its value or purchase price, shown as a percentage. It measures the unleveraged annual return from operations.
What is the cap rate formula?
Cap rate = net operating income (NOI) ÷ property value. NOI is gross rent minus vacancy and operating expenses, excluding mortgage payments.
Does cap rate include the mortgage?
No. Cap rate ignores financing. Use DSCR or cash-on-cash return to see the effect of a loan.
Is a higher cap rate better?
A higher cap rate means more income per dollar of value, but it often reflects higher risk, such as a weaker location or a property needing work.
Related guides and tools: DSCR loans in Florida · How to become a private money lender · What is ARV in real estate?
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