What Is Cap Rate?
You're looking at a duplex listed at $320,000 that generates $25,600/year in NOI after expenses. Divide $25,600 by $320,000, multiply by 100, and you get an 8% cap rate. That single number tells you the property's unlevered yield — how hard the asset works before any mortgage enters the picture. The higher the cap rate, the more income per dollar of purchase price. But "higher" doesn't automatically mean "better" — it often signals higher risk too.
Cap rate (capitalization rate) is the annual percentage return a property generates based on its net operating income divided by its purchase price or current market value. It strips out financing entirely — showing what you'd earn if you paid all cash — making it one of the fastest ways to compare deals across different markets.
At a Glance
- Formula: NOI ÷ Purchase Price × 100
- Typical range: 3% (coastal metros) to 9%+ (secondary markets)
- A 6% cap rate means you'd earn $6 for every $100 of property value annually
- Ignores mortgage payments, down payment size, and loan terms completely
- Best used to compare similar properties in similar markets — not as a standalone verdict
- Inverse relationship with property values: when cap rates compress, prices rise
Cap Rate = (NOI / Property Price) × 100
How It Works
Start with net operating income. That's your annual rental income minus operating expenses — property taxes, insurance, maintenance, management fees, vacancy losses. NOI excludes mortgage payments and capital expenditures. Important distinction.
Divide that by the purchase price (or current market value if you already own it). Done.
Emily's example from the book: she buys a property for $400,000 that nets $40,000/year in operating income. $40,000 ÷ $400,000 = 10% cap rate. That means the property pays back 10 cents on every dollar of value each year. In most markets, 10% is strong.
The formula works in reverse too — and this is where it gets useful for valuation. Say the market cap rate for similar properties is 7% and a building generates $56,000 in NOI. Divide: $56,000 ÷ 0.07 = $800,000. That's your estimated property value. Appraisers and commercial lenders do this calculation every day.
Here's the thing about cap rates and property values: they move in opposite directions. Investors flood a market, bid up prices, cap rates compress. San Jose averages 3.1% in 2026. Not because the properties are bad — demand just pushes prices so high relative to rents. Memphis? 8.4%. More income per dollar, different risk profile.
Think of it like a stock's price-to-earnings ratio. Low P/E (low cap rate) means you're paying a premium, betting on growth. High P/E (high cap rate) means more income now, but the market is pricing in risk.
Real-World Example
Marco finds two properties in different neighborhoods:
Property A (suburban Austin):
- Purchase price: $350,000
- Annual NOI: $15,750
- Cap rate: 4.5%
Property B (Cleveland suburb):
- Purchase price: $140,000
- Annual NOI: $11,200
- Cap rate: 8.0%
On paper? Property B wins. Nearly double the cap rate.
But Marco digs deeper. Austin's running 4.2% annual appreciation with strong tenant demand from the tech corridor. Cleveland's neighborhood has flat appreciation and higher turnover. The 4.5% cap rate prices in Austin's growth story. The 8.0% compensates for Cleveland's risk.
He runs both through the full stack — cash-on-cash return, DSCR, 5-year projections with leverage. Property A actually outperforms on total return. Cap rate alone would've sent him to the wrong deal.
Pros & Cons
- Quick comparison across properties without worrying about each deal's financing structure
- Financing-independent — strips out mortgage terms so you're comparing apples to apples
- Works in reverse for valuation — plug in market cap rate and NOI to estimate property value
- Widely understood by lenders, appraisers, and brokers — common language across the industry
- Easy to calculate with just two numbers: NOI and price
- Ignores financing entirely — a 7% cap rate property can produce negative cash flow if your loan rate is higher
- Single-period snapshot — captures one year of income, tells you nothing about whether NOI is climbing or falling
- Doesn't account for capital expenditures — that $35,000 roof replacement next year? Not in the cap rate
- NOI calculations vary wildly between sellers — some use trailing 12 months of actuals, others use "projected" rents that haven't materialized
- Useless across asset classes — comparing a self-storage facility's cap rate to a single-family rental tells you nothing
Watch Out
The biggest trap? Treating cap rate as the final answer instead of a screening tool.
A seller lists a property at a "9% cap rate." Sounds great. But they're using projected rents that haven't materialized and ignoring a $40,000 roof due next year. Always verify the NOI yourself. Pull actual rent rolls. Check real expense records. Confirm vacancy rates against the local market, not the seller's optimistic assumptions. A 9% cap rate built on fantasy numbers is worth exactly nothing.
Second trap: negative leverage. You buy a 5% cap rate property with a loan at 7.5% interest. Your financing costs exceed the property's unlevered return. You're losing money by borrowing. This is why cap rate alone never tells the full story — pair it with cash-on-cash return and DSCR to see what actually happens once debt enters the picture.
Ask an Investor
The Takeaway
Cap rate is your first filter, not your last. Use it to quickly screen deals and compare properties across markets — a 3-second calculation that tells you whether a property's income justifies its price. But never buy on cap rate alone. Always run the full stack: cap rate for the unlevered view, cash-on-cash return for what you actually pocket after financing, and DSCR to confirm the property can safely cover its debt. That three-metric combination gives you the complete picture that cap rate by itself can't.