What Is Cap Rate?
Cap rate (capitalization rate) is a real estate metric that measures a property's annual return independent of how it is financed. It tells you what percentage of the property's value you earn in net income each year — before accounting for your mortgage.
Cap rate is used to quickly compare properties side-by-side, assess market conditions, and determine whether an investment is priced fairly relative to its income potential.
Cap rate answers: "If I paid all cash, what annual return would I earn?" A 7% cap rate on a $300,000 property means it generates $21,000 in net income per year.
The Cap Rate Formula
What counts as operating expenses?
- Property taxes
- Insurance
- Property management fees (8-10% of rent)
- Maintenance and repairs (5% of rent)
- Capital expenditure reserves (5% of rent)
- Vacancy allowance (5-8% of potential rent)
What does NOT count in NOI: mortgage payments, income taxes, depreciation, capital improvements.
Cap Rate Example — Step by Step
Property: 3-bedroom rental home, purchase price $250,000
| Item | Monthly | Annual |
|---|---|---|
| Gross Rental Income | $1,800 | $21,600 |
| Property Taxes | ($260) | ($3,120) |
| Insurance | ($125) | ($1,500) |
| Management (9%) | ($162) | ($1,944) |
| Maintenance (5%) | ($90) | ($1,080) |
| CapEx Reserve (5%) | ($90) | ($1,080) |
| Vacancy (5%) | ($90) | ($1,080) |
| Net Operating Income (NOI) | $983 | $11,796 |
Cap Rate = $11,796 ÷ $250,000 × 100 = 4.7%
A 4.7% cap rate is below the 6% threshold most investors target. This deal might work in an appreciation market but would not be considered a cash flow deal.
What Is a Good Cap Rate?
Cap Rate by Market Type
| Market Type | Typical Cap Rate | Examples | Strategy |
|---|---|---|---|
| Primary (Tier 1) | 3–5% | NYC, LA, San Francisco | Appreciation play |
| Secondary (Tier 2) | 5–7% | Austin, Nashville, Charlotte | Balanced |
| Tertiary (Tier 3) | 7–10%+ | Memphis, Cleveland, Indianapolis | Cash flow focus |
Cap Rate vs Cash-on-Cash Return
These are two different but related metrics. Cap rate ignores financing — it measures the property's income as if purchased with all cash. Cash-on-cash return accounts for your mortgage — it measures actual cash received on actual cash invested.
A property with a 7% cap rate could have a cash-on-cash return of 12%+ if financed with leverage — because your down payment earns a return on the entire asset's income. This is the power of real estate leverage.
→ Our free analyzer calculates both automatically
Limitations of Cap Rate
- Does not account for financing. Two investors buying the same property will have the same cap rate but very different cash-on-cash returns depending on their loan terms.
- Based on current income. If rents are below market, cap rate understates the property's true potential.
- Does not capture appreciation. A low cap rate in a high-growth market may still be a great long-term investment.
- Only as accurate as your expense estimates. Garbage in, garbage out. Always use realistic expense figures.
Calculate Cap Rate on Any Property
Enter any address and our AI analyzer automatically pulls the data and calculates cap rate, cash-on-cash, DSCR, and cash flow — in under 60 seconds.
Try Free Property Analyzer →Frequently Asked Questions
Related Articles