How to Calculate Cap Rate (and What a Good One Actually Is)

The capitalization rate — cap rate — is the single most common way investors compare income properties. It answers one question: what does this property earn each year, as a percentage of what it costs? Because it ignores financing, two buyers looking at the same building see the same cap rate, which makes it a clean way to line up deals side by side.

The formula

Everything hinges on the numerator. Net operating income (NOI) is the property's annual income after operating expenses but before the mortgage. If your NOI figure is wrong, your cap rate is wrong — so it's worth building it up line by line rather than guessing. We walk through that in full in How to calculate net operating income.

A worked example

Take a small rental listed at $300,000:

A 5.7% cap rate means the property throws off 5.7 cents of net income per dollar of price each year, before any loan. Change the vacancy assumption or miss a recurring expense and that number moves — which is exactly why the assumptions matter as much as the arithmetic.

What counts as an operating expense

Operating expenses are the recurring costs of running the property:

• Property taxes and insurance
• Property management fees
• Repairs and maintenance
• Utilities you pay as the owner, HOA dues, landscaping, trash

They specifically exclude:

• Mortgage payments — cap rate is financing-independent by design
• Capital expenditures — a new roof or HVAC is a capital cost, not an operating one
• Depreciation and income taxes — accounting and tax items, not operating cash costs

Underestimating operating expenses is the most common way a cap rate ends up flattering a deal. A tidy rule of thumb is 35–45% of gross rent for a long-term rental, but that's a sanity check, not a substitute for your actual line items.

So what's a “good” cap rate?

There isn't a universal one. A cap rate is a price the market sets, and it reflects risk and growth expectations for a specific place and property type:

• Low cap rates (4–6%) tend to show up in expensive, low-risk, high-demand markets. Buyers accept a lower yield because they expect stability and appreciation.
• High cap rates (8–10%+) tend to show up in smaller or higher-risk markets. The higher yield is compensation for that risk, not a free lunch.

The right benchmark is never a national average — it's the cap rates that comparable properties in the same market recently traded at. A 7% cap rate is excellent in one city and a warning sign in another.

Where cap rate stops being useful

Cap rate is a screening tool, not a full analysis. It says nothing about your financing, your appreciation, or your taxes. Two things it deliberately can't tell you:

• Your actual return on cash. Once a loan is involved, what matters is the return on the money you put in — see cash-on-cash return.
• Whether the deal cash-flows. A healthy cap rate can still produce negative monthly cash flow after a mortgage. Cap rate is measured before debt service; your bank account isn't.

Use cap rate to compare and shortlist. Then dig into the numbers that account for how you're actually paying for the deal.