Cap rate (capitalization rate) = a property's net operating income divided by its price ... it tells you the return a property produces on its own, ignoring how you financed it. There's no single "good" number: it depends on the market and the risk. Here's how to calculate it, read it, and know when it's lying to you.
This is education, not investment advice.
The formula
Cap rate = Net Operating Income (NOI) ÷ Property price (or value)
Where NOI = rental income − operating expenses, not counting the mortgage. Example: a property with $20,000 NOI priced at $250,000 has a cap rate of $20,000 ÷ $250,000 = 8%.
The key thing: cap rate ignores financing. It measures the property's own earning power, which is why it's useful for comparing properties regardless of how each buyer pays for them.
So what's a "good" cap rate?
There's no universal answer, and anyone who gives you one is oversimplifying. Cap rate is really a risk gauge:
- Lower cap rates (say 3 to 5%) usually mean a lower-risk, higher-demand market (expensive coastal metros) where investors accept less yield for stability and appreciation.
- Higher cap rates (say 7 to 10%+) usually mean higher risk or lower-demand areas ... more yield, but more vacancy/appreciation risk.
A "good" cap rate is one that fairly compensates you for the risk of that property in that market. Compare a property's cap rate to similar properties nearby, not to a number from the internet.
When cap rate lies
Cap rate is a quick screen, and quick screens mislead:
- It ignores financing ... so it says nothing about your return. A property with a decent cap rate can be cash-flow-negative once you add a big mortgage payment. That's why investors also use cash-on-cash return, which accounts for the actual cash you invest and is especially useful for financed deals.
- It's only as honest as the NOI. If the seller's NOI understates expenses (skips maintenance, CapEx, vacancy, real management costs ... the ones people forget in cash-flow analysis), the cap rate is inflated. Rebuild the NOI yourself.
- It's a snapshot, not a forecast. It doesn't capture rent growth, appreciation, or a value-add opportunity. A cap rate describes the building as it operates today, not what you intend to do to it.
How to actually use it
- Screen fast: cap rate quickly compares properties in the same market.
- Verify the NOI: rebuild income and expenses honestly before trusting the number.
- Then check your return: run cash-on-cash with your real financing and invested capital before committing.
The come-up move
Cap rate is a fast, financing-blind read on a property's earning power ... great for comparing deals, dangerous if you stop there. Verify the NOI, then check your cash-on-cash return before you buy.
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