Cap Rate Is Not Your Return

Cap Rate Is Not Your Return

Cap rate measures the property's unlevered return, not the investor's return.

Your actual return depends on financing, tax situation, management efficiency, and holding period. Cap rate is a starting point for comparison.

What cap rate actually measures

Cap rate = NOI ÷ Purchase Price. It tells you the return the property would generate if you paid all cash — no mortgage, no leverage.

A property with $50,000 NOI that sells for $1,000,000 has a 5% cap rate. That means an all-cash buyer would earn 5% per year on their investment.

Why cap rate is not your return

Most investors use financing. When you put 25% down on that $1,000,000 property, your cash-on-cash return is not 5% — it's higher (if the leverage works) or lower (if it doesn't).

Your actual return depends on:

• Financing terms: Interest rate, amortization, and down payment dramatically change your return
• Tax situation: Depreciation, interest deductions, and your personal tax bracket affect after-tax returns
• Management efficiency: Self-managing vs. hiring a property manager changes your expenses
• Appreciation: Cap rate ignores equity growth from appreciation and principal paydown

What cap rate is good for

• Comparing properties in the same market: A 6% cap rate property vs. a 4% cap rate property tells you something about relative value
• Comparing markets: Cap rates vary by market — a 8% cap rate in a declining area may be riskier than a 5% cap rate in a growing one
• Tracking trends: Rising cap rates mean falling values (for the same NOI); falling cap rates mean rising values
• Quick screening: Cap rate lets you filter properties in seconds

Common mistakes

• "I'm getting a 7% return" — No, you're buying at a 7% cap rate. Your actual return depends on your financing and execution.
• Comparing cap rates across markets without context — A 10% cap rate in a war zone is not a better deal than a 5% cap rate in a stable, growing market.
• Ignoring what drives the cap rate — A high cap rate can mean high risk, declining area, or deferred maintenance. A low cap rate can mean strong appreciation potential or trophy location.

The principle

Use cap rate as a comparison tool, not as your expected return. Calculate your actual cash-on-cash return and IRR for the real picture. Calculate cap rate →

Part of the REI Principles collection. Restored and expanded during Wave 001.