What a cap rate actually measures
A capitalization rate is the first-year unleveraged return on a property: the net operating income you expect over the next twelve months, divided by what you pay for it. Buy a building for $1,000,000 that nets $60,000 after every operating cost, and you have bought a 6% cap rate. Nothing about your mortgage enters the calculation, which is the whole point — the cap rate describes the asset, not your deal on the asset.
That deliberate blindness to financing is why brokers, appraisers and lenders all speak in cap rates. Two investors bidding on the same fourplex may use completely different loans; they will still agree on what the building's income stream is worth relative to its price. When you want the number that does reflect your loan, use the cash-on-cash return calculator instead.
The cap rate is also a price. Markets quote it the way bond markets quote yields, and it moves inversely to value: as buyers accept lower cap rates, the same income sells for more. A property throwing off $65,000 of NOI is worth $1,000,000 at a 6.5% cap and $812,500 at an 8% cap — a 19% swing in value with the income untouched.
The IRV triangle and where NOI comes from
Appraisers teach this as IRV: income equals rate times value. Rearranged, the rate is income over value and the value is income over rate. The calculator runs both directions at once, so you can read a cap rate off a price and simultaneously read a price off a cap rate.
The hard part is never the division. It is the I. Net operating income has a strict definition and four things that people wrongly leave in or out:
- Debt service is excluded. Principal and interest are a feature of your financing, not of the building. Including them turns the cap rate into something else entirely.
- Capital expenditure is excluded from NOI, but a periodic reserve for replacements is a legitimate operating expense in institutional underwriting, and leaving it out inflates the cap rate.
- Depreciation is excluded. It is a tax entry, not a cash cost. Track it in the rental property depreciation calculator.
- Vacancy is a deduction from income, not an expense. It comes off gross scheduled rent before other income is added, which is why the calculator shows effective gross income as its own line.
Effective gross income is gross scheduled rent minus vacancy and credit loss, plus other income. Subtract operating expenses from EGI and you have NOI. The NOI calculator breaks the expense side out into individual lines if you want to build the statement from the ground up.
Worked example: an eight-unit building at $1,250,000
Eight units renting at $1,375 a month gives gross scheduled rent of 8 × 1,375 × 12 = $132,000. Coin laundry and parking add $6,000. The market runs 5% vacancy. Operating expenses — taxes, insurance, water, management at 6%, repairs and a reserve — total $48,000. The seller wants $1,250,000.
- Vacancy loss. 132,000 × 0.05 = $6,600.
- Effective gross income. 132,000 − 6,600 + 6,000 = $131,400.
- Net operating income. 131,400 − 48,000 = $83,400.
- Cap rate. 83,400 ÷ 1,250,000 = 0.06672, or 6.67%.
- Value at a 6.5% market cap. 83,400 ÷ 0.065 = $1,283,077.
- Price per unit. 1,250,000 ÷ 8 = $156,250.
- Operating expense ratio. 48,000 ÷ 131,400 = 36.5% of effective gross income.
Read step 5 against step 4: because 6.67% is above the 6.5% the market is paying, the asking price is $33,077 below what that income stream supports at market. That gap is the entire argument for the deal — and it evaporates if the $48,000 expense figure is a seller's number rather than a trailing-twelve-month actual.
How to read the number you get
There is no universally good cap rate, because the rate is a price set by the local market for that asset class. A stabilised apartment building in a coastal metro and a rural strip mall are not competing for the same capital, and their cap rates should differ by hundreds of basis points. The only benchmark that means anything is what comparable properties in the same submarket actually traded at in the last twelve months, which is what an appraiser assembles when supporting a cap rate in the income approach.
Three readings are reliable regardless of market:
- A cap rate below the loan constant is negative leverage. If your mortgage costs more per dollar of debt per year than the property earns per dollar of price, borrowing more makes your cash return worse, not better. The DSCR calculator is where that shows up first.
- An unusually high cap rate is a risk quote, not a bargain. Short lease terms, deferred maintenance, a single tenant, a declining submarket and a pro-forma rent roll all push the rate up because buyers demand compensation.
- A cap rate computed on pro-forma income is not a cap rate. If the rents in the numerator are the ones you intend to charge after renovation, you are looking at a stabilised yield-on-cost, which belongs in the BRRRR calculator, not in a comparison against market cap rates.
Note also that cap rate says nothing about growth. Two buildings at an identical 6% cap will diverge sharply if one sits in a market where rents grow 4% a year and the other in one where they are flat. The rental property ROI calculator is where appreciation and principal paydown get counted.
Value of a $10,000 income stream at each cap rate
| Cap rate | Value per $10,000 of NOI | Change from 6.0% |
|---|---|---|
| 4.0% | $250,000 | +50.0% |
| 4.5% | $222,222 | +33.3% |
| 5.0% | $200,000 | +20.0% |
| 5.5% | $181,818 | +9.1% |
| 6.0% | $166,667 | — |
| 6.5% | $153,846 | −7.7% |
| 7.0% | $142,857 | −14.3% |
| 7.5% | $133,333 | −20.0% |
| 8.0% | $125,000 | −25.0% |
| 9.0% | $111,111 | −33.3% |
| 10.0% | $100,000 | −40.0% |
Each value is 10,000 divided by the rate; each change column is that value divided by $166,667 minus one. The relationship is a hyperbola, so a half-point move costs far more value at 4% than at 10%.
Mistakes that make a cap rate wrong
- Leaving the mortgage in the expenses. The single most common error. Principal and interest are not operating expenses, and including them typically drops a 6.5% cap rate to something near 2%.
- Using the seller's expense sheet. Broker packages routinely omit management (because the owner self-manages), understate repairs, and carry a property tax figure that will reassess on sale. Rebuild expenses from the tax bill, real insurance quotes and a market management fee.
- Forgetting a capital reserve. Roofs, boilers and parking lots fail on a schedule. Institutional underwriting carries a per-unit annual reserve; omitting it makes the cap rate look better than the building performs.
- Mixing pro-forma income with market cap rates. Comparable sales are capitalised on in-place income. Comparing your post-renovation NOI against those rates double-counts the value you have not created yet.
- Capitalising a single unusual year. A year with an eviction, a roof claim or a large one-off legal bill is not the income stream a buyer is purchasing. Normalise, and say so.
- Treating cap rate as a return you receive. It is a return on the whole purchase price with no debt. Almost nobody buys that way, so it is a comparison metric, not a forecast of your bank balance.
Where cap rate sits among the other yardsticks
Cap rate is a screening tool. It answers one question — what is this income stream worth relative to its price — quickly and comparably, and it answers nothing else. Four neighbours fill the gaps.
Gross rent multiplier is cap rate's cruder cousin: price divided by gross rent, no expenses at all. It is fast enough for scanning a hundred listings and useless for a decision, because it cannot see that one building pays its own heat. The gross rent multiplier calculator shows how the two relate.
Cash-on-cash return divides after-debt cash flow by the cash you actually put in. It is the number that tells you what the deal does for you rather than what the building does for anyone.
Internal rate of return discounts the whole hold — cash flow, refinance, sale — into a single annualised figure, and is the only one of the four that values timing. Use the real estate IRR calculator when the exit matters.
Band of investment derives a cap rate from the market rather than reading one off a sale, by weighting the mortgage constant and the equity dividend rate by their shares of the capital stack. Appraisers use it when sale comparables are thin; see the band of investment cap rate calculator.
One convention to watch outside the United States: much of Europe, Australia and the UK quote a yield rather than a cap rate, and a gross yield at that — annual rent over price, with no expense deduction and often no vacancy allowance. Those numbers are not comparable to a US cap rate and will read one to three points higher on the same building. The rental yield calculator handles that convention directly.
Reserves, and why two honest people get different cap rates
The Appraisal Institute's income approach treats a replacement reserve as an operating expense; many private sellers do not. On the eight-unit example above, a $300-per-unit annual reserve is $2,400, which moves NOI from $83,400 to $81,000 and the cap rate from 6.67% to 6.48%. Neither figure is dishonest — but if you compare your reserve-inclusive cap rate against broker quotes computed without one, you will systematically conclude that every property is overpriced. State your convention and apply it to both sides of every comparison.