What Is Cap Rate and How to Calculate It

Cap rate (capitalization rate) is the ratio of a property's net operating income to its value. It tells you the unlevered return — the return the property produces before financing.

Cap Rate = NOI ÷ Property Value

If a property generates $18,000 in NOI and is worth $225,000, the cap rate is 8%.

What Cap Rate Does NOT Measure

Cap rate is not the investor's return. It does not account for:

• The loan (debt service)
• The down payment
• Tax benefits or depreciation
• Appreciation
• Equity build-up

Cap rate measures the property's operating yield — not what you put in your pocket.

How to Use Cap Rate

Cap rate is most useful for three things:

1. Comparing properties — a property with a 7% cap rate produces more income per dollar of value than one at 5%, all else equal
2. Estimating value — if market cap rates are 7% and a property generates $18,000 NOI, the indicated value is approximately $257,000 ($18,000 ÷ 0.07)
3. Tracking markets — falling cap rates mean rising values (if NOI is stable); rising cap rates mean falling values

The Inverse Relationship

Cap rate and value move inversely. When cap rates fall (investors accept lower yields), values rise. When cap rates rise, values fall. This is why cap rate compression in hot markets can make properties look expensive on day one but look like bargains in hindsight if the trend continues.

Limitations

Cap rate is a snapshot — one year's NOI divided by today's value. It doesn't capture:

• Future rent growth or expense inflation
• The cost of deferred maintenance
• The risk of a declining neighborhood
• The impact of financing on your actual return

A property with a high cap rate may have a high cap rate because it's risky — not because it's a good deal. Always ask why the cap rate is what it is before assuming it's an opportunity.

The Principle

Cap rate measures the property's unlevered return, not the investor's return. Don't confuse the property's yield with your yield.

Your actual return depends on your financing, your tax situation, your management efficiency, and your holding period. Cap rate is a starting point for comparison — not the final word on whether a deal is good.