Cap Rate (Capitalization Rate)
Cap rate (capitalization rate) is the ratio of a property's net operating income (NOI) to its purchase price or value. It expresses the annual return an investor would receive if the property were purchased for cash, excluding financing and appreciation. Cap rates are used to compare income-producing real estate and to estimate value.
Formula
Cap Rate = Net Operating Income (NOI) / Property Value (or Purchase Price)
NOI is gross rental income minus operating expenses (property tax, insurance, maintenance, management, utilities if landlord-paid). It excludes debt service, depreciation, and capital improvements. Cap rate is typically expressed as a percentage.
Example
A property generates $40,000 in NOI and is valued at $500,000. Cap rate = $40,000 / $500,000 = 0.08, or 8%. An 8% cap rate implies an 8% annual return on the purchase price, assuming NOI remains constant.
Relationship to ROI
Cap rate is a form of yield-based return metric. For an all-cash purchase with stable NOI, cap rate approximates the first-year ROI from operating income. It does not include appreciation, financing leverage, or sale proceeds. Total ROI on a real estate investment typically combines income yield with price change over the holding period. Our ROI Calculator can help with total return calculations.
Interpretation
Higher cap rates generally indicate higher perceived risk or lower growth expectations; lower cap rates suggest lower risk or higher growth. Cap rates vary by market, property type, and condition. Comparing cap rates across similar properties helps assess relative value.
Caveats
Cap rate assumes NOI is stable and does not account for future changes in rent or expenses. It ignores financing, so leveraged returns will differ. Vacancy and expense estimates affect NOI and thus cap rate; different assumptions produce different results.