What Is a Cap Rate? How Investors Price Income Property

The formula

Cap rate = net operating income ÷ price.

A four-unit building rents each apartment for $1,500 a month, which is $72,000 a year if every unit is always full. They won't be, so allow for a 5% vacancy rate, which brings the realistic rent to $68,400. Property taxes, insurance, repairs, management, utilities the owner pays and a reserve for big replacements come to $24,400. That leaves $44,000 of net operating income.

If the building costs $640,000, the cap rate is $44,000 ÷ $640,000, about 6.9%.

Getting net operating income right

NOI is income minus the costs of operating the property. It leaves out mortgage payments, because those depend on how the buyer finances the purchase rather than on the property itself. It also leaves out depreciation, an accounting entry with no cash attached.

Most mistakes happen here, and they usually flatter the property. A seller's figures might use the rents they hope to charge rather than the rents tenants pay, leave out a property manager because the owner does the work personally, or skip the reserve for a new roof. Rebuild NOI from leases, tax bills and insurance quotes before trusting any cap rate you're shown.

What a cap rate says about a property

A higher cap rate means more income per dollar of price. That usually reflects more risk or less expected growth: an older building, a weaker location, tenants who move often, rents with little room to rise. A lower cap rate means buyers are paying more per dollar of income, because they see the income as safer or expect it to grow.

So a "good" cap rate depends on what you're comparing. Compare properties of the same type in the same market at the same time, and ask why one is priced at a higher cap rate than its neighbors before assuming it's a bargain.

A cap rate is also a multiple turned upside down. A 6.9% cap rate means paying about 14.5 times the property's yearly NOI.

Value moves with NOI

Because price equals NOI divided by the cap rate, every dollar of added NOI adds many dollars of value. Raise the building's NOI by $5,000 a year, through a rent increase or a lower insurance bill, and at the same 6.9% cap rate the building is worth about $72,700 more.

That's why investors pore over expense lines that look trivial. A $100-a-month saving is $1,200 a year of NOI and roughly $17,500 of value at this cap rate.

What financing does to the return

The cap rate ignores the mortgage. Your actual return depends on it. Put 25% down, $160,000, and borrow $480,000 at 7% over 30 years, and the loan payments come to about $38,300 a year.

$44,000 of NOI minus $38,300 of debt payments leaves about $5,700 of cash flow on $160,000 of cash invested: a cash-on-cash return of about 3.5%, below the property's 6.9% cap rate.

That's negative leverage. When the loan's yearly payments are a bigger share of the loan than the property's cap rate, borrowing lowers your cash return instead of raising it. The loan here costs about 8% of its balance a year in payments, against a 6.9% yield. Buyers in that position are usually betting on rising rents or values, and it's worth knowing that's the bet. Lenders will also look at debt service coverage, here $44,000 ÷ $38,300, about 1.15, which leaves little cushion.

Why interest rates move prices

Cap rates tend to rise when interest rates do, though not in lockstep. Investors can earn more elsewhere, borrowing costs more, and buyers demand a higher yield from property to compensate.

The effect on value is large. If buyers in the building's market start demanding 7.5% instead of 6.9%, the same $44,000 of NOI is worth about $587,000 instead of $640,000, roughly 8% less, with nothing about the building itself having changed.

The same idea prices businesses

Any asset that produces income can be priced this way. A small business selling for four times its yearly earnings has an earnings yield of 25%, its own version of a cap rate.

Small businesses usually trade at much higher yields than apartment buildings, because their earnings are less certain and often depend on the owner. The logic is the same: price is income divided by the return a buyer needs for the risk.

Key takeaways

• Cap rate = net operating income ÷ price, a property's yearly yield before financing.
• NOI subtracts vacancy and all operating costs, but not mortgage payments or depreciation. Rebuild it yourself before trusting it.
• Higher cap rates usually signal more risk or less growth; compare only within the same property type and market.
• When the loan's payments are a larger share of the loan than the cap rate, borrowing lowers your cash return.

Frequently asked questions

What is a good cap rate?

It depends on the property type, the location, interest rates and the risk you're willing to take. A higher cap rate means more income for the price and usually more risk. Compare a property with similar ones in the same market rather than with a single target number.

Does the cap rate include the mortgage?

No. Cap rate uses net operating income, which is calculated before any debt payments, so it measures the property's return as if bought with cash. Cash-on-cash return is the measure that includes financing.

How do you calculate a property's value from its cap rate?

Divide net operating income by the cap rate. A property with $50,000 of NOI in a market where similar properties sell at a 6% cap rate would be valued at about $833,000.