What Is a Cap Rate in Real Estate?

Jacob Lavian
Sep 17
3 min read

If you’re googling what is a cap rate in real estate, here’s the plain answer: a capitalization rate (cap rate) is the property’s annual Net Operating Income (NOI) divided by its purchase price or value. It’s a quick way to compare income-producing properties on yield before financing.

Cap Rate = NOI ÷ Price

Higher cap rate → higher yield, usually more risk/lower price.
Lower cap rate → lower yield, usually less risk/higher price.

How to calculate cap rate (step-by-step)

Start with Gross Income (rents + recurring fees).
Subtract Vacancy/Credit Loss to get Effective Gross Income.
Subtract Operating Expenses (taxes, insurance, management, repairs, utilities you pay, reserves).
That equals NOI.
Divide NOI by the price/value.

Example:

Gross income: $160,000
Vacancy (5%): –$8,000 → Effective gross: $152,000
Operating expenses: –$32,000 → NOI = $120,000
Price: $2,000,000
Cap rate = 120,000 ÷ 2,000,000 = 0.06 = 6%

Reverse pricing:If stabilized NOI is $219,000 and market buyers pay ~6%, value ≈ $219,000 ÷ 0.06 = $3,650,000.

What’s included in NOI (and what isn’t)

Included (typical operating items):property taxes, insurance, repairs/maintenance, management, common utilities, admin, reserves.

Excluded: mortgage payments, capital improvements, income taxes, depreciation, leasing costs on the buy year (often handled in underwriting but not in simple NOI).

Cap rate compares property income only—it ignores your specific loan terms.

What is a “good” cap rate?

It depends on risk, location, tenant/lease quality, and growth prospects. Core locations and long, credit-backed leases usually trade at lower cap rates; smaller properties, weaker credit, short terms, or heavy work trade at higher cap rates. Don’t chase a number in isolation—judge NOI quality and the path to income.

Cap rate vs. other metrics

Cap rate vs. Cash-on-Cash: cap is pre-debt; cash-on-cash includes your financing and down payment.
Cap rate vs. IRR: cap is a snapshot; IRR models cash flows over time (rent growth, sale price, capital costs).
Cap rate vs. GRM: GRM uses gross rent; cap rate uses NOI and is more informative.

How buyers use cap rates (smartly)

Screen deals fast: Compare stabilized cap rates across similar assets to see what merits a deeper look.
Stress test NOI: Verify vacancy assumptions, tax reset, management, and reserves—thin NOI = misleading cap.
Pair with DSCR: Even a “great” cap can fail lender tests if leases are short or expenses are underwritten differently. (See our DSCR explainer.)

How sellers use cap rates (to maximize net)

Price from stabilized NOI. Document a believable path (rent comps, TI/free-rent norms, timeline).
Show the story. Clear expenses, taxes after sale, and a leasing plan reduce retrades.
Invite multiple offers. A tight process often improves both price and terms—deposits, contingencies, estoppels.

Common mistakes with cap rates

Using pro-forma income only with no support.
Ignoring taxes after sale (assessed value reset can shrink NOI).
Comparing across apples and oranges (asset type/market/lease length).
Forgetting reserves and management in expenses.
Mixing trailing figures (last year) with next year’s projections.

Quick answers (FAQ)

Does cap rate include the mortgage? No—cap rate is before debt. Your loan shows up in cash-on-cash and DSCR, not cap rate.

Can cap rate be negative? If NOI is negative (expenses exceed income), yes—but that’s a sign to re-underwrite.

Is a higher cap rate always better? Not necessarily. It can signal more risk (location, vacancy, credit, capital needs). Look at NOI quality and lease terms.

Bottom line

Cap rate is a fast, financing-agnostic yardstick: NOI ÷ Price. Use it to compare similar properties, then dig into NOI quality, lease risk, and capital needs before deciding. Sellers should price off supported stabilized NOI; buyers should pair cap rate with cash-on-cash, IRR, and DSCR for the real picture.

Want a quick read on cap rate and value for a specific property? Contact me—share the address and income/expense snapshot and I’ll send back a supported range.