What is cap rate?
Cap rate, short for capitalization rate, is the percentage return a rental property earns before financing. It is calculated by dividing the property's net operating income (NOI) by its purchase price. NOI is the annual rent the property collects after subtracting vacancy and operating expenses, but before any mortgage payment. While a higher cap rate typically suggests greater potential returns, it often comes with higher risk.
How to calculate cap rate
Start with annual gross rent (monthly rent times twelve). Subtract vacancy losses (typically 5 percent of gross rent). Subtract operating expenses (property taxes, insurance, maintenance, property management, HOA, other). What remains is net operating income (NOI). Divide NOI by purchase price, then multiply by one hundred to express as a percentage.
For example, a property bought at $500,000 with $4,000 monthly rent and 40 percent expense ratio: gross annual rent is $48,000, expenses are $19,200, NOI is $28,800. Cap rate is $28,800 divided by $500,000, or 5.76 percent.
What is a good cap rate?
Cap rates for rental properties typically range from 4 to 10 percent. The right number depends on your strategy. Cash flow investors usually target 7 percent or higher to ensure strong monthly income. Appreciation investors in coastal or growth markets often accept lower cap rates (4 to 6 percent) because they expect property value appreciation to drive total returns.
Above 8 percent is generally considered strong for cash flow markets like the Midwest and parts of the South. Below 4 percent often signals an appreciation play or a property in a prime location where land value drives the price.
Common cap rate mistakes
Ignoring vacancy
Even in hot rental markets, factor in 5 to 10 percent vacancy. A property that sits empty for one month per year loses 8 percent of its potential rent.
Underestimating expenses
New investors often forget routine maintenance, property management fees (8 to 10 percent of rent), capital expenditures (roof, HVAC), and HOA (Homeowners Association) fees. The 40 percent rule (operating expenses equal 40 percent of gross rent) is a useful starting estimate.
Comparing across markets without context
A 5 percent cap rate in San Francisco and a 9 percent cap rate in Cleveland are not directly comparable. Different markets have different growth, tenant quality, and risk profiles. Always compare within similar market segments.
Cap rate vs other metrics
Cap rate measures pre-financing return. It excludes mortgage payments and is useful for comparing investment properties on equal footing. Cash-on-cash return measures post-financing return on the cash you put in (down payment + closing + rehab). Gross rent multiplier (GRM) is a quicker but cruder ratio of price to annual rent — useful for back-of-the-envelope screening before you commit to a full cap-rate calculation. For a complete picture, evaluate all three alongside appreciation potential and tax benefits.
How cap rate fits into a full deal analysis
Cap rate is one input. A complete deal analysis also includes financing terms, projected appreciation, repair costs, neighborhood class, rent comps, and the specific tax treatment of the property. Cylier delivers all of these for any US address. Start with the cap rate calculator above, then run a full deep analysis on a property you are seriously considering.
Cap rate FAQ
- What is a cap rate?
- Cap rate (capitalization rate) is the percentage return a rental property earns before financing, computed as net operating income divided by purchase price.
- How do you calculate cap rate?
- Divide annual net operating income (gross rent minus vacancy and expenses) by the purchase price, then multiply by 100 to express as a percentage.
- What is a good cap rate for a rental property?
- Rental cap rates typically range from 4% to 10%. Above 8% is generally considered strong for cash flow markets; appreciation markets often run lower.
- What is NOI in real estate?
- Net Operating Income is the annual income from a rental property after subtracting vacancy losses and operating expenses, but before mortgage payments and taxes.