What is a cap rate?
The capitalization rate — "cap rate" for short — is the rate of return an investment property would generate if purchased entirely with cash. It's calculated as Net Operating Income ÷ Property Value. Cap rates let you compare properties of different sizes, prices, and locations on an apples-to-apples basis.
What NOI includes (and excludes)
NOI = Gross rental income − vacancy − operating expenses. Critically, NOI excludes mortgage payments, depreciation, and capital expenditures. Operating expenses include property taxes, insurance, maintenance, property management fees, and utilities paid by the owner. The exclusion of financing is what makes cap rate a "pure" measure of the property's income potential.
Cap rates by property type (2025)
- Class A multifamily (urban): 4–5%
- Class B/C multifamily: 5–7%
- Single-tenant retail (NNN): 5.5–7%
- Office (varies wildly by market): 6–10%
- Industrial: 5.5–7%
- Single-family rentals: 6–9%
Lower cap rates indicate either higher-quality assets (less risk) or overpriced properties. Higher cap rates indicate either riskier assets or undervalued opportunities. The same 6% cap rate can mean very different things in downtown Manhattan versus rural Mississippi.
Frequently asked questions
What is a good cap rate?
It depends on the asset class and market. Class A multifamily in major cities: 4-5%. Class B/C multifamily: 5-7%. Single-tenant retail (NNN): 5.5-7%. Office: 6-10%. Industrial: 5.5-7%. Single-family rentals: 6-9%. Lower cap rates indicate either higher-quality assets or overpriced properties.
Why doesn't cap rate include mortgage payments?
Cap rate measures the property's income potential independent of financing. The same property has the same cap rate whether you pay cash or finance it. This lets you compare properties on an apples-to-apples basis. To account for financing, use cash-on-cash return instead.
What is the difference between cap rate and cash-on-cash return?
Cap rate = NOI ÷ property value (pure property return, ignoring financing). Cash-on-cash = (NOI − debt service) ÷ cash invested (includes financing). Cap rate is for comparing properties; cash-on-cash is for evaluating your actual investment return.
Does cap rate include depreciation?
No. Cap rate is a pre-tax, pre-financing metric. Depreciation is a tax benefit that reduces your taxable income but doesn't affect cash flow. Cap rate reflects cash flow only.
How do I value a property using cap rate?
Value = NOI ÷ desired cap rate. If a property generates $80,000 NOI and you want a 7% return, the property is worth ~$1,143,000 to you. If market cap rates are 6%, the market values it at $1,333,000. Cap rates compress as prices rise.
What is 'cap rate compression'?
When cap rates fall (e.g., from 7% to 5%), property values rise for the same NOI. This happened dramatically from 2010-2022 as low interest rates drove investors to accept lower yields. Cap rate expansion (rates rising) does the opposite — values fall.
Should I buy properties with low or high cap rates?
It depends on your strategy. Low cap rates (4-5%) = lower cash flow but typically better locations, higher appreciation potential, lower risk. High cap rates (8-10%) = higher cash flow but typically worse locations, lower appreciation, higher risk. Match the strategy to your goals.
Glossary of key terms
- NOI (Net Operating Income)
- Gross rental income minus vacancy minus operating expenses. Does NOT include debt service, depreciation, or CapEx.
- Cap Rate
- NOI ÷ property value. The rate of return if you paid all cash. Pure property measure.
- Operating Expenses
- Property taxes, insurance, maintenance, management fees, utilities. Excludes mortgage payments, depreciation, CapEx.
- Cap Rate Compression
- When cap rates fall (typically due to low interest rates), property values rise for the same NOI.
- NNN (Triple Net)
- Lease structure where tenant pays taxes, insurance, and maintenance. Common in commercial real estate.
Common mistakes to avoid
- Including mortgage payments in NOI — cap rate is a pure property metric
- Using pro forma (projected) rents instead of actual rents — actual is what matters
- Forgetting to subtract vacancy from gross income
- Comparing cap rates across different property types (multifamily vs office vs retail)
- Ignoring market context — a 6% cap rate in Manhattan is different from 6% in rural Mississippi
Pro tips
- Always use actual rents, not pro forma — sellers always project optimistic rents.
- Compare cap rates only within the same asset class and submarket.
- Factor in CapEx reserves separately from operating expenses — they're real costs but lumpy.
- When interest rates rise, cap rates typically rise too — meaning property values fall. Lock in long-term fixed-rate debt when rates are low.
- Buy value-add properties (below-market rents, deferred maintenance) — increase NOI through renovations and rent increases, which increases value at the same cap rate.
Results are estimates for educational purposes only and not financial advice. Consult a licensed professional for advice specific to your situation.