How to Calculate and Identify a Good Cap Rate

A property’s capitalization rate, or cap rate for short, offers a quick, back-of-the-napkin calculation to approximate its returns. While it’s not the final word on investment property returns, it makes a great starting point.

Cap rates measure a property’s income relative to its cost. As such, they’re useful for comparing income properties such as rentals or commercial properties for buy-and-hold investors, but don’t apply to fix-and-flip investments.

What are cap rates’ strengths and limitations, and what calculations should you use in conjunction with cap rates? How do you find a market’s cap rate, and how do you predict which way it will move?

If you invest in income properties, make sure you understand cap rates’ uses — and their limitations.

How to calculate cap rates

The formula for calculating cap rates is simple enough:

Net operating income (NOI) ÷ purchase price (or current market value)

Of course, it immediately raises a follow-up question for beginner investors: How do you calculate net operating income (NOI)? Fortunately, that’s just as simple.

You calculate NOI by subtracting the following annual expenses from the gross rental revenue:

Property taxes
Insurance
Maintenance and repairs
Vacancy rate
Property management fees

Sample cap rate calculation

Say you’re considering a property priced at $100,000 that rents for $1,000 per month. It generates a gross income of $12,000 per year, and you subtract out the following expenses:

Property taxes: $1,500
Insurance: $800
Maintenance and repairs: $1,800
Vacancy rate: $700 (~6%)
Property management fees: $1,200 (including the occasional new tenant placement)

Those expenses come to $6,000 per year, so when subtracted from your $12,000 gross annual income, that gives you an NOI of $6,000. You then divide that $6,000 NOI by the $100,000 purchase price to reach a 6% cap rate.

Is that good? Bad? It lies somewhere in the normal or average range—because unfortunately, what makes a “good” or “bad” cap rate varies dramatically by area. But the real value of cap rates doesn’t necessarily lie in their insights into a single property, but rather as a comparison tool.

Advantages of cap rates

Yes, cap rates offer a useful shorthand estimate of a property’s potential income yield. But other calculations can provide a better analysis of individual property returns, which raises the question of how cap rates actually serve you as a real estate investor.

Quickly compare similar properties

Rental, multifamily, and commercial investors use cap rates as a universal calculation that they can apply to any property, anywhere, to quickly compare potential yields.

Imagine that two identical properties are available for sale, right next to each other. Both properties are currently in almost equivalent condition and require similar repairs. One offers a cap rate of 6.5%, the other 7%. All else being equal, you should buy the one that offers the higher cap rate, because it offers a higher potential income yield.

The problem is that in the real world, all else is never equal. One property will be older or in poorer condition, or it may have a slightly better location, or it may appeal to a different typeof tenant. More on that shortly.

Even so, cap rates serve as a universal yardstick for fast, easy comparison of potential yields.

Identify potential cities and neighborhoods for investment

Cap rates also provide a quick way to identify markets with potentially higher returns.

An overpriced coastal city might only offer a citywide average cap rate of 2%. Meanwhile, a more affordable but still thriving Midwestern city could see average cap rates of 6%. As a rental investor, that tells me to take a closer look at that Midwestern city and leave the overpriced coastal city to new real estate investors who don’t know any better.

You can also use cap rates to compare neighborhoods within a city. Some neighborhoods offer better cap rates than others, and surveying the city’s neighborhoods can help you find the sweet spot between risk and return.

Which raises an important point: higher cap rates generally mean lower-income neighborhoods. The higher the average neighborhood income, the lower the risk of rent defaults, turnovers, vacancies, and other variables which can affect your cash flow. So investors are willing to accept lower yields in these more stable, higher-income neighborhoods.

Your goal as a real estate investor isn’t to find the neighborhood with the highest cap rate in the country. Your goal is to find the best balance of higher yields without higher risk or headaches.

Limitations of cap rates

Cap rates provide an oversimplified perspective of income properties. This simplicity is their greatest strength, but also their limitation.

Ultimately, too many novice investors overemphasize cap rates while overlooking a more nuanced property analysis.

Cap rates ignore hidden costs

As alluded to above, cap rates fail to capture every expense or headache that landlords and investors face.

Lower-income neighborhoods tend to offer high cap rates, but finding reliable tenants can be more difficult. These neighborhoods tend to have higher rent default rates and turnover rates. Because tenants tend to deal with more financial and social pressures, paying rent on time may not always be their top priority. Plus, high vacancy rates indicating attracting and keeping good tenants can be a challenge.

And as experienced rental investors know, turnovers are where all the labor, headaches, and expenses lie for landlords.

Cap rates ignore financing

If you’ve ever bought a car and chosen between an instant rebate and 0% financing, you know that financing can have a huge impact on your costs. And, in real estate investing, on your returns.

Imagine you could buy one property with a 20% down payment and a 6% interest rate, but your lender won’t touch another property in a worse neighborhood offering higher cap rates. For that neighborhood, you go to a backup lender, and put down 25% and pay 7.5% interest.

Because you’ll need to put down more money and pay higher interest, your ultimate cash-on-cash return will be negatively affected. In this situation, cap rate may provide a rosier picture than the reality—which is why a high cap rate isn’t always a pro.

Other calculations investors should use

So when it comes time for due diligence on individual properties, what calculations should you use?

Cash-on-cash return

If you plan to buy with financing, what ultimately matters most is your cash-on-cash return: the return on investment that you see from your own dollars tied up in the deal.

A property with a slightly higher cap rate can be a worse investment, if you can’t finance it with the same favorable terms as another property with a slightly lower cap rate. Take the time to run the cash-on-cash return calculations for every property you seriously consider and compare the real ROI you’d earn on your money.

Monthly cash flow

Similarly, calculate the monthly cash flow — both gross and net — that you can expect from any given property.

You may discover that even a property with a decent cap rate just doesn’t generate enough net cash flow to be worth the headaches of buying and managing it. That goes doubly for Class B or Class C rentals!

How to find a market’s cap rate

The best tool I’ve found for researching market cap rates is Mashvisor. They provide data on the city, neighborhood, and zip code levels, to help you identify both promising cities and neighborhoods within them for income investing. I love that Mashvisor lets you calculate both long-term rentals and short-term vacation rentals in any given market to help you decide on the best investing model for any given location.

For detailed property information, check out the BPInsights Property Insights feature. It provides the median rent, as well as the 25th and 75th percentile, so you can dial in on specific factors that could affect your investment.

Predicting cap rate movements

As a broad rule, you can get a sense for which way cap rates in any given market are moving based on how rent changes compare to price changes.

When prices rise faster than rents, expect diminishing cap rates. When rents rise faster, cap rates will likely rise.

Start with Zillow as a simple way to review a market’s current rent and price movements. Also check out Rentometer as another source for rental market data.

A property with a 2% cap rate probably isn’t worth the hassle. A property with a 12% cap rate probably sits in a high-risk, high-turnover area.

But don’t necessarily write off properties with particularly high or low cap rates. Instead, think of cap rates as one more tool in your investing toolkit, a way to tell if you’re on the right track.

Create a real estate investing strategy that balances risk and return and use cap rates as a gauge to help you estimate both. Ideally, look to score excellent deals on properties in areas with moderate cap rates, so that your individual property’s cap rate comes out ahead.

What kind of cap rates do you typically aim for? What have your experiences been when you’ve invested at higher or lower cap rates?

Tell us in the comments below.