What Is Cap Rate?

Cap rate = NOI ÷ property value. Express the result as a percentage by multiplying by 100. Example: NOI $50,000 and value $625,000 → cap rate 8.0%. If you know desired cap rate and NOI, implied value = NOI ÷ cap rate—useful for back-of-envelope offer pricing.

NOI is gross rental income minus operating expenses, before mortgage payments, capital expenditures, and income taxes. The value denominator is typically purchase price or current market value, not original cost basis. Stabilized NOI—after normalized vacancy and management assumptions—is standard for comparison; pro forma NOI from a broker OM may inflate income or understate expenses.

Cap rate is only as reliable as the NOI input. Overstated rent roll, omitted vacancy, or missing management fees inflates NOI and artificially lowers cap rate, making a deal look better than operational reality. Conservative investors recalculate NOI with their own vacancy factor (often 5–10% for multifamily) and expense line items before trusting marketed cap rates.

NOI excludes debt service, so cap rate measures unlevered property performance. Two investors buying the same building at the same price calculate identical cap rates regardless of financing. Their cash-on-cash returns will differ based on down payment, interest rate, and amortization—cap rate will not capture that divergence.

Cash-on-cash return = annual pre-tax cash flow after debt service ÷ total cash invested (down payment plus closing costs). A property with 6% cap rate might yield 10% cash-on-cash with favorable leverage—or negative cash flow with aggressive financing despite a respectable cap rate.

Use cap rate to compare unlevered asset pricing across markets and property types at a high level. Use cash-on-cash when evaluating whether your specific financing structure produces acceptable wallet returns. The rental deal analyzer combines both perspectives with loan terms, reserves, and closing costs for a complete picture. A deal can screen well on cap rate yet fail your cash-on-cash hurdle if the lender requires heavy down payment or charges above-market interest.

Higher cap rates generally indicate higher perceived risk, lower growth expectations, or less desirable locations. Lower cap rates often reflect stable cash flow, strong tenant demand, and institutional competition for core assets. There is no universal "good" cap rate—multifamily in a growing secondary city might trade at 5.5–6.5% while rural retail sits at 8–10%.

Compare cap rates among similar assets: same property type, similar age and condition, same submarket. A Class B office cap rate means little next to a Class A multifamily cap rate. Use GRM (gross rent multiplier) when expense data is thin; graduate to cap rate once you can underwrite NOI with confidence.

Consider a four-unit building asking $480,000. Gross scheduled rent $48,000/year. Vacancy and credit loss 5% ($2,400). Effective gross income $45,600. Operating expenses: taxes $4,800, insurance $2,400, maintenance $3,600, management 8% of EGI ($3,648), utilities $1,200—total $15,648. NOI = $45,600 − $15,648 = $29,952.

Cap rate = $29,952 ÷ $480,000 = 6.24%. If comparable sales in the neighborhood cluster around 7%, the asking price may be aggressive unless rents are below market and you can raise income post-close. If your lender requires 1.25 DSCR on a $320,000 loan at 7% interest, debt service might consume most of NOI—cap rate alone would not reveal tight cash flow, which is why layered analysis matters.

Cap rate compresses (falls) in markets where investors expect rent growth, limited supply, or institutional demand—think core multifamily in supply-constrained cities. Cap rate expands when perceived risk rises: deferred maintenance, expiring leases below market, or declining population trends. Track trailing cap rates from actual sales, not just broker pro formas, using CoStar, Reonomy, or local broker market reports.

Cap rate ignores hold period, tax benefits, renovation upside, and time value of money. Internal rate of return (IRR) and equity multiple require multi-year cash flow projections. Use cap rate as a first-pass filter, then underwrite full returns before making offers on assets above your target threshold.