Cap Rate Explained: How to Evaluate a Rental Property
Capitalization rate (cap rate) is the most widely used shorthand for evaluating income-producing real estate. It lets you compare properties of different sizes and prices on equal footing.
The Formula
Cap rate = Net Operating Income (NOI) ÷ Current Market Value × 100. NOI = gross rental income − operating expenses (maintenance, insurance, property management, taxes). It does NOT subtract mortgage payments — cap rate is a property metric, independent of financing.
What "Good" Looks Like
Cap rates vary by market and property type. In expensive urban markets, cap rates of 3–5% are common. Suburban or rural markets may yield 6–10%. Higher cap rate = higher return but often higher risk (older buildings, weaker rental demand). Lower cap rate = more stable income but less upside. Compare cap rates within the same submarket, not across cities.
Cap Rate vs. Cash-on-Cash Return
Cap rate ignores financing. Cash-on-cash return measures actual cash flow relative to your cash invested (down payment + closing costs). Two investors buying the same property at the same cap rate can have very different cash-on-cash returns based on their loan terms. Use cap rate to compare deals; use cash-on-cash to evaluate your personal return.
Limitations to Keep in Mind
Cap rate uses current income and value — both can change. Vacancy rate assumptions matter: a property projected at 95% occupancy that runs at 80% will underperform. Always stress-test NOI with a conservative vacancy assumption (10–15%) before making an offer.