Cap Rate Explained: The Complete Guide to Capitalization Rates in Real Estate

What is Cap Rate?

Cap rate measures the relationship between a property's net operating income (NOI) and its market value. Think of it as the "yield" on a real estate investment, similar to the yield on a bond.

A property with a 6% cap rate generates income equal to 6% of its value each year.

Key characteristics:

• Expressed as a percentage
• Ignores financing (assumes all-cash purchase)
• Based on annual net operating income
• Allows direct comparison between properties

Cap rate strips out financing decisions so you can compare properties on equal footing. Two investors looking at the same property will calculate the same cap rate, regardless of how they plan to finance it.

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The Cap Rate Formula

Cap Rate = Net Operating Income (NOI) ÷ Property Value × 100

Net Operating Income (NOI): Annual rental income minus operating expenses. Does NOT include mortgage payments, depreciation, or capital expenditures.

Property Value: Either the purchase price or current market value.

What's Included in NOI?

The most common mistake is including mortgage payments in expenses. Mortgage is a financing decision, not an operating expense. That's why cap rate ignores it.

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Step-by-Step Cap Rate Calculation

Example 1: Single-Family Rental

Property details:

• Purchase price: $350,000
• Monthly rent: $2,400

Calculate annual income:

Gross rental income: $2,400 × 12 = $28,800

Calculate annual operating expenses:

Vacancy allowance (5%):     $1,440
Property taxes:             $4,200
Insurance:                  $1,400
Property management (8%):   $2,304
Repairs and maintenance:    $2,000
─────────────────────────────────
Total operating expenses:   $11,344

Calculate NOI:

NOI = $28,800 - $11,344 = $17,456

Calculate cap rate:

Cap Rate = $17,456 ÷ $350,000 × 100 = 4.99%

This property has approximately a 5% cap rate.

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Example 2: Small Multifamily (4-Unit)

Property details:

• Purchase price: $800,000
• Rent per unit: $1,500/month
• 4 units total

Calculate annual income:

Gross rental income: $1,500 × 4 × 12 = $72,000

Calculate annual operating expenses:

Vacancy allowance (7%):     $5,040
Property taxes:             $9,600
Insurance:                  $3,200
Property management (10%):  $7,200
Repairs and maintenance:    $6,000
Common area utilities:      $2,400
─────────────────────────────────
Total operating expenses:   $33,440

Calculate NOI:

NOI = $72,000 - $33,440 = $38,560

Calculate cap rate:

Cap Rate = $38,560 ÷ $800,000 × 100 = 4.82%

This 4-unit property has approximately a 4.8% cap rate.

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What is a Good Cap Rate?

There's no universal "good" cap rate. It depends on your investment goals, risk tolerance, and the market you're investing in. Here's the framework:

The Cap Rate Trade-Off

Lower cap rates are not necessarily worse investments.

Lower cap rates (3-5%) typically mean:

• More desirable locations
• Higher-quality tenants
• Lower vacancy risk
• Better appreciation potential
• Less immediate cash flow

Higher cap rates (8%+) typically mean:

• Less competitive markets
• More management-intensive
• Higher vacancy risk
• More immediate cash flow
• Less appreciation potential

A 4.5% cap rate in Austin may outperform a 9% cap rate in a declining market over 10 years because appreciation and rent growth matter.

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Cap Rates by Property Type (2025)

Different property types trade at different cap rates due to varying risk profiles. According to Marcus & Millichap's Q1 2025 research, here are current ranges:

Multifamily Cap Rates

Multifamily cap rates compressed 7 basis points during Q1 2025, and this trend is expected to continue.

Industrial Cap Rates

Industrial saw cap rates compress by 5 basis points in Q1 2025.

All Property Types Overview

According to CBRE's H1 2025 Cap Rate Survey, the all-property cap rate estimate declined 9 basis points, signaling that cap rates may have peaked.

CBRE projects that from their 2024 peak to end of 2025, industrial cap rates will fall by 30 basis points, retail by 24 bps, and multifamily by 17 bps.

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Factors That Affect Cap Rates

1. Location

The same property type can have dramatically different cap rates by location:

A 5.5% cap rate in Denver may represent similar risk-adjusted returns as a 8% cap rate in a smaller market.

2. Property Class

• Class A: Newest buildings, best locations, highest rents → Lower cap rates
• Class B: Good condition, solid locations, moderate rents → Middle cap rates
• Class C: Older buildings, value-add opportunities → Higher cap rates

3. Interest Rates

Cap rates generally move with interest rates, though not perfectly correlated. According to Marcus & Millichap research, movements in the 10-Year Treasury yield are only 40% correlated with movements in average apartment cap rates.

More correlated: transaction velocity. The correlation between changes in the number of trades and movements in cap rates since 2001 was 78%.

4. Market Cycle

• Expansion: Strong demand, cap rates compress (prices rise)
• Peak: Lowest cap rates, highest prices
• Contraction: Demand falls, cap rates expand (prices drop)
• Recovery: Cap rates stabilize

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Cap Rate Limitations

Cap rate is useful for quick comparisons, but it has significant blind spots.

1. Ignores Financing

Cap rate assumes an all-cash purchase. Two investors buying the same property with different loan terms will have different actual returns.

Example:

Property: $1,000,000 at 6% cap rate = $60,000 NOI

Investor A (all cash): 6% return on investment
Investor B (75% LTV at 7% interest): Cash-on-cash return of ~3-4%

When financing matters, use cash-on-cash return instead.

2. Single Year Snapshot

Cap rate only looks at one year's income. It doesn't account for:

• Rent growth potential
• Future capital expenditures (roof, HVAC)
• Lease expirations
• Market trends

For multi-year projections, use IRR or DCF analysis.

3. NOI Can Be Manipulated

Sellers may present:

• "Pro forma" NOI based on projections, not actual performance
• Understated expense assumptions
• Above-market rents from expiring leases

Always verify NOI with trailing 12-month financials (T-12), rent rolls, and actual expense records.

4. Doesn't Work for Value-Add Deals

Cap rate is based on current income. If a property is 50% vacant or has below-market rents, the current cap rate is meaningless.

For value-add, use purchase price per unit and calculate projected stabilized cap rate after improvements.

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Cap Rate vs Other Metrics

When to Use Cap Rate

• Comparing similar properties in the same market
• Quick initial screening of opportunities
• Estimating property value from income
• Analyzing all-cash purchase scenarios

When to Use Something Else

• Evaluating a specific loan scenario: Use cash-on-cash return
• Projecting returns over 5-10 years: Use IRR
• Analyzing a value-add deal: Use price per unit plus projected stabilized cap rate
• Quick screening before deep analysis: Use GRM

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Using Cap Rate to Estimate Property Value

Cap rate works in reverse. If you know the NOI and market cap rate, you can estimate what a property should be worth:

Property Value = NOI ÷ Cap Rate

Example: Valuing an Apartment Building

Given:

• Net Operating Income: $150,000/year
• Market cap rate for similar properties: 5.5%

Estimated value:

Value = $150,000 ÷ 0.055 = $2,727,273

This property should trade around $2.7 million based on its income.

The Cap Rate Compression Effect

Small changes in cap rate have massive impacts on property value:

A 1.5% drop in cap rate (from 6.5% to 5.0%) increases property value by $692,308, a 30% increase, with no change in income.

This is why cap rate compression during low interest rate environments created enormous wealth for property owners.

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FAQ

What's the difference between cap rate and ROI?

Cap rate measures unlevered return based on property income only. ROI is broader and typically includes appreciation, tax benefits, and financing effects. Cap rate is consistent across all buyers; ROI varies based on individual circumstances and hold period.

Why are cap rates so low in cities like San Francisco and New York?

Gateway cities have high demand, limited supply, strong appreciation potential, and wealthy buyer pools willing to accept lower current income. Investors in these markets prioritize long-term appreciation and stability over immediate cash flow. Lower cap rates also reflect lower perceived risk.

Is a higher cap rate always better?

No. Higher cap rates often signal higher risk: challenging locations, deferred maintenance, tenant quality issues, or economic uncertainty. A 10% cap rate in a declining market may underperform a 5% cap rate in a growing one over time. Always understand why the cap rate is what it is.

How do I find cap rate data for a specific market?

Several sources:

• CBRE Cap Rate Surveys (semi-annual, free)
• Marcus & Millichap Research (quarterly briefs)
• Local commercial brokers can share recent transaction data
• LoopNet listings show asking cap rates (though may be optimistic)

Should I use asking price or my offer price for cap rate?

Both are useful. Calculate cap rate at the seller's asking price to see if their pricing is realistic. Then calculate at your offer price to ensure it meets your return requirements. The difference reveals negotiating room.

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Key Takeaways

1. Cap rate = NOI ÷ Property Value: Measures unlevered return on a property
2. "Good" cap rates vary: 4.5-5.5% for Class A multifamily, 6-8% in secondary markets
3. Lower cap rate doesn't mean worse deal: May indicate lower risk and better appreciation
4. Always verify NOI: Pro forma numbers can be misleading
5. Use cap rate for comparison: Switch to cash-on-cash when evaluating financing
6. Small cap rate changes = massive value swings: Understand the compression math

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Calculate Your Cap Rate

Ready to analyze a property? Use our cap rate calculator to run the numbers and compare investment opportunities.

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Related Reading

• Cash-on-Cash Return Guide: Learn how to evaluate leveraged returns
• Break-Even Occupancy Analysis: Understand your risk tolerance
• NOI Calculator: Calculate net operating income accurately