What Is a Cap Rate?

Most explanations of cap rate start with the wrong question. They ask what it measures, then answer with a definition that sounds like a promise. The cap rate is not a promise of what you will earn. It is a price multiple turned upside down. When someone tells you a building sold at a 6% cap rate, they are telling you the price was 16.7 times the net operating income. The number is a snapshot of a market transaction, not a forecast. Asking what is cap rate in real estate is really asking how buyers in a given market are pricing income. The answer tells you what they are willing to pay for a dollar of net operating income, before they consider debt, growth, or the cost of fixing the roof.

The cap rate is the net operating income of a property divided by its price, expressed as a percentage, and it tells you the current yield on that price before financing.

That sentence is the whole concept. The capitalization rate definition is not more complicated than that. It is the ratio between the net operating income produced by an asset and the capital cost to buy that asset, as the Appraisal Institute defines it in The Appraisal of Real Estate. The ratio is a current yield, not a return on your cash and not a measure of profit. It is a measure of price. If the price doubles and the income stays the same, the cap rate halves. If the income doubles and the price stays the same, the cap rate doubles. The number only changes when the market changes the price or the building changes its income.

Take a small apartment building with a net operating income of $74,000. A buyer pays $1,000,000 for it. The cap rate is $74,000 divided by $1,000,000, which is 7.4%. That is the current yield on the price. The buyer did not earn 7.4% on the cash they put in, because they did not put in $1,000,000. They put in a down payment and borrowed the rest. The cap rate ignores the loan entirely.

Now take the same building and imagine the seller drops the price to $800,000. The income is still $74,000. The cap rate is now 9.25%. The price fell, so the yield on that lower price rose. The opposite happens when the price rises. If the building sells for $1,200,000, the cap rate drops to 6.17%. The income did not change. The price did. That is the cap rate real estate investors watch, because it tells them what the market is doing to prices for a given level of income.

A cap rate is three things at once. It is a current yield, a price multiple, and a market signal about risk. As a yield, it tells you the annual net operating income as a percentage of the price. As a price multiple, it is the inverse of the price-to-income ratio. A 5% cap rate means a price of 20 times income. A 10% cap rate means a price of 10 times income.

As a risk signal, the cap rate compresses when investors see safety and expands when they see danger. A building in a stable downtown with long-term tenants might trade at a 4% cap rate. A motel on a highway with monthly rentals might trade at a 9% cap rate. The higher rate compensates for vacancy risk, tenant quality, and the cost of keeping the asset competitive. That is why cap rate explained to a beginner usually leans on the risk story, but the more useful habit is to read the rate as a price signal first and a risk signal second.

The cap rate is a pre-leverage, pre-tax, pre-growth number. It ignores the mortgage, so it cannot tell you your cash-on-cash return. It ignores rent growth, so it cannot tell you your total return. It ignores capital expenditures, so it can overstate what you actually keep. And it ignores taxes, so it cannot tell you your after-tax yield.

This is not a flaw in the cap rate. It is the point of the cap rate. The number is a common denominator that lets you compare two buildings as if both were bought with cash and held forever. The moment you add debt, you are looking at a different return, one that depends on your interest rate, your amortization schedule, and your tax bracket. The moment you add rent growth, you are looking at total return, which Geltner et al. define in Commercial Real Estate Analysis and Investments as the cap rate plus income growth plus the appreciation component. A building with a 5% cap rate and 3% annual rent growth can beat a building with a 7% cap rate and flat rents. The cap rate alone cannot show you that.

Cap rates are not published by a central authority. They are derived from closed sales. When a building sells, the buyer and seller agree on a price. If the building had a known net operating income, the sale implies a cap rate. That implied rate becomes a data point. A broker or appraiser collects several of these points, adjusts for differences in location and condition, and produces a market cap rate for a given property type in a given submarket.

This is why a single cap rate for a city is a fiction. The cap rate for a Class A office building in the central business district is different from the cap rate for a small retail strip in the suburbs. […] Appraisers use direct capitalization to value a property by dividing a single-year NOI by a cap rate derived from comparable sales. […] lag them. The reason is that the cap rate is not set in a vacuum. It is set in competition with other investments. […] The risk-free rate is usually the 10-year Treasury. The risk premium compensates for the chance that the building does not perform. The liquidity premium compensates for the fact that real estate is hard to sell. The management premium compensates for the work of running the asset. Add them together and you get the cap rate. […] When the 10-year moves, cap rates move, but slowly, because the other three components do not move overnight.

The cap rate is not your cash-on-cash return. […] The two numbers are only equal if you pay all cash.

The cap rate is also not the discount rate. The discount rate is the required total return used to bring future cash flows to present value. The cap rate is a current yield on a single year's income. They are only equal if there is no growth and no change in the exit cap rate, which is a mathematical special case, not a market reality. Using one when you mean the other is a common error in real estate analysis. […]

The most common mistake is using trailing NOI without adjusting for a one-time repair or a non-market rent. […] The fix is to use stabilized NOI, which is what the property would produce at market rents with normal vacancy and operating expenses.

Another mistake is confusing the purchase price with the appraised value. The cap rate is based on the price paid, not the appraisal. […] The price is a fact.

A third mistake is using a survey cap rate as a target without adjusting for your specific property. A generic number from a market report is a starting point, not a conclusion. Your building may have better tenants, worse condition, or a better location than the average. […] It does not tell you whether the price is right for you. That depends on your cost of capital, your holding period, and your tolerance for vacancy.

A low cap rate on a stable asset can be a better investment than a high cap rate on a risky one, because the low cap rate usually comes with […] A high cap rate usually means the market expects trouble, so the income may be overstated or the expenses understated.

If you are comparing two properties, use the cap rate as a screen, not a verdict. The property with the higher cap rate is not automatically the better buy. […] The cap rate is the entry point, not the conclusion.

What is a good cap rate for a rental property?

There is no universal good cap rate. […] A good cap rate is one that compensates you for the risk you are taking. […] Compare the cap rate to the 10-year Treasury yield plus a risk premium. If the spread is too thin, the price is probably too high.

How do I calculate the cap rate on a property I already own?

Divide the net operating income by the current market value, not the original purchase price. […] The cap rate on current value is what a new buyer would earn, which is what the market is actually pricing.

Can the cap rate change after I buy?

Yes. […] If you sell, the cap rate on your sale is the new buyer's yield, which may be higher or lower than what you bought at.

Is the cap rate the same as the yield?

In real estate, the cap rate is often called the yield, especially […] The two are not the same. The cap rate ignores the return of principal, which is a real cost in a building that wears out.

What should I do if the cap rate seems too good to be true?

Check the NOI. A cap rate that is far above the market average usually means the NOI is overstated or the expenses are understated. Look for one-time rent, below-market expenses, or deferred maintenance. […] High cap rates exist for a reason, and the reason is usually something you have not found yet.

A building with a 5% cap rate and 3% annual rent growth can beat a building with a 7% cap rate and flat rents, so the cap rate alone cannot tell you which is the better investment."