The formula and what it means
Cap rate = Net Operating Income (NOI) ÷ Property Value. NOI is gross rental income minus vacancy and collection loss minus all operating expenses (property taxes, insurance, management, maintenance, utilities) — before debt service. Cap rate is a financing-neutral metric: it measures how much income the property generates relative to its purchase price, ignoring how you financed it.
Example: A building with $80,000 NOI sold for $1,000,000 has an 8% cap rate. The same building generating $80,000 NOI at a 5% cap rate would be priced at $1,600,000. The formula also works in reverse: if you know the cap rate for your market and the NOI, you can estimate the property's value.
Cap rate vs. cash-on-cash return
Cap rate and cash-on-cash return look similar but measure different things. Cap rate is pre-debt (ignores your mortgage); cash-on-cash return is post-debt (measures cash flow on your actual cash invested). A property can have a 6% cap rate but a 12% cash-on-cash return if the mortgage rate is below the cap rate — this is positive leverage. If your mortgage rate exceeds the cap rate, leverage is negative and cash-on-cash will be lower than the cap rate.
Use the cap rate to compare properties in the market on an apples-to-apples basis, and cash-on-cash return to evaluate your specific return given your financing terms.
Market cap rates and what they signal
Cap rates vary by location, property type, tenant quality, and economic conditions. A lower cap rate means investors are paying more per dollar of income — signaling high demand, low perceived risk, or strong appreciation expectations. A higher cap rate means more income per dollar invested but also potentially more risk, lower demand, or a secondary market location. Cap rates and interest rates tend to move together over time; when the 10-year Treasury yield rises, cap rates often follow, putting downward pressure on property prices.
Frequently asked questions
What does a lower cap rate mean?
A lower cap rate means a higher purchase price relative to income — investors are accepting a smaller yield, often because they expect appreciation or see less risk. Urban core properties in major markets typically trade at lower cap rates.
Is cap rate the same as return on investment?
No. Cap rate is a pre-debt income yield on the total property value. ROI and cash-on-cash return incorporate your actual equity and financing terms.
How do I calculate NOI for a cap rate?
NOI = gross rents − vacancy − operating expenses. Do not subtract mortgage payments — cap rate is pre-debt.
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.