What is cap rate?
The capitalization rate — cap rate — is the most widely used metric for evaluating income-producing real estate. It measures the annual return a property generates relative to its value, assuming an all-cash purchase. Cap rate strips out financing so you can compare properties on the same footing regardless of how they're funded.
The formula is straightforward: Cap Rate = Net Operating Income ÷ Property Value. A property generating $24,000 of NOI purchased for $400,000 has a 6% cap rate. The inverse is also true — if you know a market trades at 6% cap rates, a property with $24,000 NOI should be worth roughly $400,000.
The cap rate formula
What goes into NOI — and what doesn't
Getting NOI right is where most beginner investors make mistakes. NOI is income after operating expenses but before mortgage payments, depreciation and income taxes. It is a property-level metric, not an investor-level metric.
Included in NOI
- Gross rent (all units)
- Less: vacancy & credit loss
- Less: property taxes
- Less: insurance
- Less: property management fees
- Less: maintenance & repairs
- Less: utilities (landlord-paid)
- Less: HOA / common area costs
Not included in NOI
- Mortgage principal & interest
- Depreciation
- Income tax
- Capital expenditures (roof, HVAC)
- Loan origination fees
- Personal expenses
- Closing costs at purchase
- Investor's own management time
Capital expenditures (CapEx) are the most commonly omitted item. A roof replacement or HVAC system is not an operating expense — it's a capital cost. But failing to reserve for it means your NOI is overstated and your actual return lower than the cap rate implies. A CapEx reserve of 5–10% of gross rents is standard practice for older properties.
Cap rate benchmarks by US market
Cap rates vary significantly by market, property type and asset class. Higher cap rates signal higher perceived risk or lower demand — not necessarily better investments. Lower cap rates in gateway cities reflect rent growth expectations and liquidity premium.
| Market | Residential cap rate | Signal |
|---|---|---|
| San Francisco / NYC | 3.5–4.5% | Low yield, high appreciation bet |
| Los Angeles / Seattle | 4.0–5.0% | Competitive, supply-constrained |
| Austin / Denver / Nashville | 5.0–6.5% | Growth markets, balanced risk |
| Phoenix / Atlanta / Dallas | 5.5–7.0% | Strong cash flow + appreciation |
| Midwest: Columbus, Indianapolis | 7.0–9.0% | High cash flow, lower appreciation |
| Secondary / rural markets | 8.0–11%+ | Illiquidity premium, higher risk |
These are approximate 2026 ranges for stabilized residential rentals. Commercial, multifamily and short-term rental assets trade at different cap rates. Always verify current comps with a local broker — cap rates can shift 100–150bps within 12 months in fast-moving markets.
Cap rate vs cash-on-cash return
Cap rate and cash-on-cash (CoC) return are related but measure different things. Cap rate is financing-agnostic — it tells you about the property. Cash-on-cash measures your actual cash return on the equity you deployed, including the effect of leverage.
In this example, leverage improved the cash-on-cash return above the cap rate. But leverage works both ways — if NOI falls (vacancy spike, rent drop), the cash flow shrinks while the mortgage payment stays fixed. At higher interest rates, debt service can consume most or all of the NOI, turning a 6% cap rate property into near-zero cash flow.
The cap rate and interest rate relationship
Cap rates and interest rates are closely linked. When the risk-free rate (US Treasuries) rises, investors demand higher cap rates to compensate — otherwise a bond yields more than a property for less risk. The spread between cap rates and the 10-year Treasury typically runs 150–250 basis points. When that spread compresses below 100bps, property is arguably overpriced relative to bonds.
| 10-yr Treasury | Typical cap rate floor | Spread | Market signal |
|---|---|---|---|
| 1.5% (2021) | 4.0–5.0% | 250–350bps | Property attractive vs bonds |
| 3.5% (2022) | 5.0–6.0% | 150–250bps | Neutral — repricing underway |
| 4.5% (2024–26) | 5.5–7.0% | 100–250bps | Selective — market-dependent |
Cap rate is a valuation and comparison tool — not a measure of your actual return. A 7% cap rate in Indianapolis is not the same investment as a 4% cap rate in San Francisco: risk profile, liquidity, appreciation potential and tenant quality differ significantly. Use cap rate to screen and compare deals, then model the full return including leverage, CapEx reserves, tax benefits and exit assumptions before committing capital.