Capitalization rate is the most commonly cited number in investment real estate and the most commonly misapplied one. Investors use it to screen deals, compare markets, and value properties. They also use it incorrectly often enough that understanding what it actually measures - and what it does not - is worth some attention.
Cap rate is simple arithmetic. What it reveals is more nuanced.
The formula
Cap rate equals net operating income divided by property value.
Net operating income (NOI) is gross rental income minus all operating expenses, not including mortgage payments. It is a property-level metric that does not depend on how the property is financed.
A property generating $30,000 in annual gross rent with $10,000 in operating expenses has an NOI of $20,000. At a purchase price of $300,000, the cap rate is 6.7%.
The same property at a purchase price of $250,000 has a cap rate of 8%. At $400,000, it is 5%.
This illustrates the key relationship: cap rate moves inversely with price. When prices rise, cap rates compress. When prices fall, cap rates expand. A market with compressing cap rates is one where buyers are accepting lower returns for the same income - typically because they expect prices to keep rising.
What cap rates tell you about markets
Cap rates are not uniform. They vary by market, property type, property age, and tenant quality.
Primary markets - New York, Los Angeles, San Francisco, Boston - have historically traded at 4-5% cap rates for multifamily. Investors accept lower current returns because they believe in long-term appreciation and liquidity. Secondary markets like Nashville, Denver, and Austin have typically offered 5-6.5%. Tertiary markets offer 7-9% cap rates but with thinner liquidity and less predictable appreciation.
CoStar's cap rate data tracks these spreads in real time across property types. The spread between primary and tertiary market cap rates compresses in boom cycles and widens in downturns as investors flee to quality.
Single-family rentals are not typically valued by cap rate in the same way commercial properties are - comparable sales drive single-family pricing. But the underlying income analysis is the same.
The limits of cap rate
It ignores financing. Cap rate says nothing about whether a deal cash flows after your mortgage payment. A 6% cap rate property financed at 7.5% is cash flow negative from day one. Cash-on-cash return, not cap rate, tells you what actually lands in your account.
It is only as good as the NOI figure. Sellers and brokers construct pro forma NOIs using optimistic occupancy assumptions and understated expenses. Always stress-test the NOI with actual expense history and conservative vacancy estimates before applying a cap rate.
It does not capture future income growth. A property with below-market in-place rents and strong lease-up potential may trade at a lower apparent cap rate than a fully stabilized asset - but the forward NOI, once rents are marked to market, tells a different story.
It does not capture location quality. Two properties with identical cap rates in different markets are not equivalent investments. The one in the growing market with better liquidity and appreciation prospects is a better asset.
How to use cap rates in practice
Use cap rate as a first screen, not a final answer. When evaluating a deal, compare the going-in cap rate to:
- Market cap rates for comparable properties (your local broker or a Bankrate investment property guide can help calibrate market norms)
- The prevailing financing rate - a deal where the cap rate is below your borrowing cost has negative leverage from day one
- Your return targets - if you need 7% cash-on-cash and can only achieve 4% cap rate in a market, the math requires either a large down payment or finding a better market
Sophisticated buyers also calculate the "going-out" cap rate - what they expect to sell the property at in five to ten years based on projected NOI growth. The difference between going-in and going-out cap rates, combined with cash flow and principal paydown, drives the total return picture.
This article is for informational purposes only and does not constitute financial, legal, or tax advice. Consult a qualified professional before making investment decisions.
