Guides · 2 minute read

What is cap rate?

A clean way to compare a property’s income with its price, before the mortgage enters the picture.

Capitalization rate, usually shortened to cap rate, estimates the annual operating return a property produces relative to what it costs. It treats the property as if you bought it with cash, so financing choices do not distort the comparison.

The formulaCap rate = annual net operating income ÷ purchase price

If a property costs $300,000 and produces $21,000 in annual net operating income, its cap rate is 7%. That does not mean you will pocket 7% after your mortgage. It means the building’s operations produce 7% of its price before debt service and income taxes.

Start with net operating income

Net operating income, or NOI, is rental income after vacancy and normal operating expenses. Those expenses usually include property taxes, insurance, repairs and maintenance, property management, owner-paid utilities, landscaping and association fees.

Mortgage principal and interest do not belong in NOI. Neither do one-time closing costs, major capital projects like a new roof, or your personal income tax. Keeping them out lets two buyers with different loans evaluate the same property on equal footing.

A worked example

Say a duplex rents for $3,000 a month, or $36,000 a year. You assume 5% vacancy ($1,800), leaving $34,200. Taxes, insurance, repairs, management and utilities add up to $13,200. NOI is $34,200 − $13,200 = $21,000. At a $300,000 price, the cap rate is 7%.

Try it with your own numbersThe quick cap rate calculator does this math as you type.

What makes a “good” cap rate?

There is no universal target. A lower cap rate can reflect a stable property in an expensive, high-demand market, where buyers accept less income today for expected growth. A higher one can signal more work, more volatility, or a weaker location. Many small-rental investors screen for roughly 5% to 8%, but the right number depends on your market, the property type and your alternatives.

The useful move is comparison. Look at similar properties serving similar tenants in the same market, then ask why one yield differs from another. A cap rate that looks too good usually has a reason: deferred maintenance, understated expenses, or rent that is above the market.

What cap rate misses

  • Your mortgage rate, down payment and cash flow after debt.
  • Large repairs, renovations and near-term capital spending.
  • Future rent growth or changes in value.
  • The time and difficulty of managing the property.

Use cap rate as a first comparison, then move to cash flow and cash-on-cash return for the financing-specific picture.

Common questions

What is the cap rate formula?

Cap rate equals annual net operating income divided by the purchase price. Net operating income is rent after vacancy minus operating expenses, and it excludes mortgage payments.

What is a good cap rate for a rental property?

There is no single answer. Many small-rental investors look for about 5% to 8%, but expensive markets often trade at lower cap rates and riskier or lower-demand markets at higher ones. Compare similar properties in the same area.

Does cap rate include the mortgage?

No. Cap rate ignores financing on purpose so you can compare properties on their operating performance alone. Cash-on-cash return is the measure that includes your loan.

Is a higher cap rate always better?

Not necessarily. A high cap rate can reflect higher risk, deferred maintenance or a weaker market. It is a starting point for questions, not a verdict.

Educational content, not investment, tax, legal or lending advice. Last updated .