What is Capitalization Rate (Cap Rate)?
The Capitalization Rate, commonly known as Cap Rate, is one of the most fundamental metrics in real estate investing. It measures the rate of return on a rental property based on the income the property is expected to generate. The cap rate allows investors to compare the profitability of different properties regardless of how they are financed.
Unlike Cash-on-Cash return, Cap Rate ignores debt service (mortgage payments). This makes it a pure measure of the property's ability to generate revenue relative to its market value or purchase price.
How to Calculate Cap Rate
The formula for calculating Cap Rate is straightforward but requires accurate inputs to be effective:
Where:
- Net Operating Income (NOI): This is your Annual Gross Rental Income minus all Annual Operating Expenses.
- Property Value: The current market value or the purchase price of the asset.
Understanding the Inputs
To get an accurate result from the Cap Rate Calculator, you must ensure your NOI calculation is precise. Operating expenses should include:
- Property Taxes
- Landlord Insurance
- Property Management Fees
- Maintenance and Repairs
- Vacancy Allowances
- Utilities (if landlord-paid)
Note: Do not deduct mortgage principal or interest payments when calculating NOI for Cap Rate.
What is a Good Cap Rate?
There is no single "good" cap rate that applies to every situation, as it varies significantly by location and asset class. However, general guidelines suggest:
- 4% – 5%: Common in high-demand, low-risk areas (like Manhattan or San Francisco). These properties usually have high appreciation potential.
- 6% – 8%: Often considered a healthy balance between risk and return for residential single-family or multi-family homes in stable suburban markets.
- 10%+: Often found in riskier neighborhoods or rural areas where property values are lower, but management intensity might be higher.
Why Use a Cap Rate Calculator?
Using a calculator speeds up the initial screening process. When evaluating dozens of potential deals, an investor can quickly discard properties with dangerously low cap rates that don't justify the purchase price. It acts as a quick filter before diving into deeper cash flow analysis.
Cap Rate vs. ROI
While often used interchangeably in casual conversation, Cap Rate and ROI (Return on Investment) differ. Cap Rate assesses the property's raw potential assuming an all-cash purchase. ROI typically accounts for the leverage (mortgage) used to buy the property, providing a picture of the return on the actual cash invested.