Real Estate Deal Analysis & Advice

How to Use Cap Rates as a Rental Property Investor (Hint: You’re Probably Doing It Wrong)

Expertise: Commercial Real Estate
18 Articles Written
Looking-for-work

Cap rate is such an easy target to pick on. And it's no wonder given that there so much confusion, misinformation, misunderstanding, and misapplication on the definition and use of the concept.

Want more articles like this?

Create an account today to get BiggerPocket's best blog articles delivered to your inbox

Sign up for free

I tried to clear some of this up in my recent article “The Truth About Cap Rate: 5 Myths—Busted.” But as the marketing folks on late night TV say, “But wait, there’s more!”

What Cap Rate Is NOT (& What It Is)

Not to beat a dead horse here, but it’s so important that it’s worth saying again—cap rate is not a measurement of investment performance or return, it is a measurement of market sentiment.

Think of cap rate as a reverse thermometer measuring the market. As the market heats up, buyers place a higher value on the income stream because they see upside, and that pushes cap rates down. This is called cap rate compression.

As the market cools off, buyers back off and are only willing to buy the same income stream for a lower price. This causes cap rates to decompress, or rise. This makes sense, because a growing income stream is justifiably more valuable than a static or shrinking one.

Related: How to Calculate Cap Rate (& Where Many People Get It Wrong)

Cap Rates Vary Based on Several Factors

Cap rates are not uniform across markets or property types. Apartments built in 1980 in a good neighborhood might be selling at a 5% cap rate in Dallas, a 4.5% cap rate in San Francisco, and a 6.5% cap rate in Kansas City. Newer properties tend to sell at lower cap rates than older ones, and better neighborhoods command lower cap rates than war-zone neighborhoods.

This also makes perfect sense. If a property produces $1,000 per year of income, you expect fewer problems with a new property in a great area. But with an old property in a bad area, you would expect all sorts of problems.

For the same income, you are willing to pay a higher price for the newer property because you see less risk, and thus you’ll accept a lower return. For the older property, you want to pay a lower price because the higher risk means that you may or may not get $1,000 in the future—it depends on a lot more unknowns.

Sectors all have their own cap rates. In the same neighborhood, you might find apartments selling at a 6% cap rate, office buildings at 7%, industrial at 8%, retail at 9%, and hotels at 9.5%. The cap rate depends on how these sectors are performing and many other factors that affect risk and investment returns.

Where to Find Data Surrounding Cap Rates

Learning what general market cap rates are for any sector, area, and class is easier said than done. If you underwrite a lot of property and follow those properties until learning the price they sell for, you can get a feel for cap rates based on your own observations. For more macro-level data, you could turn to the Cap Rate Survey that is published by the commercial real estate brokerage CBRE twice per year and is available online for free. Or you could look at the appraisal that your lender is sure to order.

But one word of advice—deciding how much to pay isn’t as simple as dividing the property’s net operating income (NOI) by the cap rate. Your purchase price should be decided by backing into the desired investment return, not by a simple grade-school division problem.

Related: Multifamily Myths: Why You Don’t Control The Value Like Everyone Says You Do

How to Use Cap Rate Correctly

With all sorts of variables affecting cap rates, what good are they?

real estate investment small plastic property models on wooden surface with notepad, calculator, smartphone, male hands in view

If used properly, cap rates are helpful for evaluating one thing and one thing only: the ultimate exit price of the property. In other words, the price you can sell the property for at the intended point of sale.

Using a cap rate that similar properties in the same area are selling for, you can forecast your approximate sale price. Truth be told, your actual exit sale price is likely to be way off of your estimate, in one direction or the other, but you’ve got to start somewhere, right?

For example, let’s say you are buying an apartment complex built in 1980, and you plan to sell it in five years. Other apartment complexes of the same vintage within a reasonable distance in similar neighborhoods are selling at a 5% cap rate. If you think that the market is going to remain the same as today, you can divide your projected year five income by 5% and arrive at an estimated sale price.

If you think that the market today is trading near a peak, and that perhaps the future is less certain, you might choose to divide your year five income by a higher cap rate, such as 5.5% or even 6%. This part is a bit art, a bit science.

Wrapping Up

Cap rate is not the driver; it is the passenger. Rather than saying cap rates went up so prices went down, it’s more accurate to say that prices went down, so cap rates went up.

Cap rate shouldn't be the primary factor in your selection of real estate investments, nor should you set your purchase price based solely on cap rate. Cap rate is simply a way of measuring, after the price has been decided, how much you were willing to pay for the property's income stream so that people (including you) can make relative comparisons between this acquisition and other similar acquisitions in the same area.

Cap rate is most useful for estimating the price that the property will later be sold for, so that you can estimate the proceeds from the sale. The sale proceeds will be an important part of calculating the internal rate of return (IRR) and equity multiple.

IRR, cash-on-cash return, and equity multiple—not cap rate—should be used to determine the right price to pay for the property and to decide the quality and suitability of a real estate investment.

Brian Burke Hands Off Investor book ad

Questions? Comments?

Let’s talk below. 

Brian Burke is president/CEO of Praxis Capital Inc, a vertically integrated real estate private equity investment firm, and author of
Read more
    Barry H. Investor from Scottsdale, AZ
    Replied 5 months ago
    BRIAN - This is a nice look at Cap rates and how they relate to acquisition and sale as opposed to the science behind calculating Cap rates. I liked your quote: "...If used properly, cap rates are helpful for evaluating one thing and one thing only: the ultimate exit price of the property. In other words, the price you can sell the property for at the intended point of sale...." You also mentioned Kansas City (KC) in your article. I am a Turn Key seller in KC with tenants already in place and I provide seller financing (25% down). I like your example because I always presume zero appreciation for any property I purchase OR sell. It takes away the posturing. To me, a rental property, if properly maintained, will sell for whet you bought it for, whether 1, 5 or 10 years later. With loan costs and all Cap Expenditures, the fully remodeled Turn Key properties I sell in KC produce 20%+ annual ROI for my Buyers (not Cap rate). I call it ROI to keep it simple and not confuse it with Cap Rates. Thanks for a brief but accurate summary on Cap rates !!
    Brian Burke Investor from Santa Rosa, CA
    Replied 5 months ago
    It is very true that ROI (whether measured as IRR or CoC) is completely different than cap rate. Yet the confusion continues to surface...
    Alex Olson Real Estate Agent from kansas City, MO area
    Replied 5 months ago
    As always, great work Brian. keep up the good work. I think your cap rate is spot on for kc.
    Brian Burke Investor from Santa Rosa, CA
    Replied 5 months ago
    Thanks Alex!
    Paul Shannon Rental Property Investor from Fishers, IN
    Replied 5 months ago
    Brian - this is thought provoking post, thank you. In regards to apartment repositioning, obviously if you raise income on the top line or reduce expenses on the bottom line, you are going to improve NOI. At the same cap rate, you’d have improved the value of the property. Do you believe those improvements can compress the cap rate at the same time within say 12 months? (ie. Buy at at 7 cap and sell at a 6 cap).
    Brian Burke Investor from Santa Rosa, CA
    Replied 5 months ago
    It does the opposite, Paul. Improving the property actually increases the cap rate. Remember in the article that I mentioned that a growing income stream is more valuable than a static or shrinking one? If you improve the property, you carve some, most, or all of the meat off the bone. This leaves less upside for the next owner, and thus, the next owner doesn't see the income stream as valuable as you did. This nuance is usually pretty small, however. If a value-add property trades at a 6% cap rate, the same deal stabilized might be a 6.25% - 6.5%, give or take. The goal is for the improvements to pull the income (and thus the value) up more than the headwind of the decompressing cap rate pushes against you. It's a delicate balance, and why most value-add investors don't rehab all of the units. Leave some upside for the next guy...
    Mike Waller remodeling contractor from Birmingham, AL
    Replied 5 months ago
    Thank you for explaining, I am one of those who wasn't quite sure what the cap rate actually represents.
    Brian Burke Investor from Santa Rosa, CA
    Replied 5 months ago
    You aren't alone, Mike. Check out my article from last week that is linked in the introduction to the article. You'll see a lot of reasons why cap rate is such a complex and debated topic.
    Anthony O. Porter Rental Property Investor from Atlanta, GA
    Replied 5 months ago
    Brian- Thank you for this article. It was very helpful to me as a new commercial real estate investor and very timely. In my analysis I am always using the cap rate to determine the price I should pay for the property, in addition to whether there are upside such as increasing the rent or reducing expenses, which inturn will increase my ROI and value of the property for my exit. Still trying to find my first CRE residential property of 5 to 20 units. Once again, thanks for the article
    Brian Burke Investor from Santa Rosa, CA
    Replied 5 months ago
    Happy to share it, Anthony. I hope it helps you refine your methods so you can finally score that first CRE deal!
    Jeremy Salvatori
    Replied 5 months ago
    For those who remember their SAT analogies. Cap Rates : Real Estate :: PE Ratios : Stocks
    Nina Grayson Investor from Los Angeles, CA
    Replied 5 months ago
    Great article, Brian. I use a range of Cap Rates to analyze the current position based on T12 and then on Market. I then compare those price ranges to recently traded assets to see where the property reasonably lands. I find its an easier way to see how overpriced (and yes, this is often the case with proforma) the seller's ask is to it's current position. Then I leverage IRR, CoC, and EM to negotiate the acquisition, since I have an expectation to meet for my investors. I may play with Barry's zero no posturing approach and not assume all units will be improved. I may be able to achieve a more realistic actual YoY ROI that I can give more assurance on rather than assumptive appreciations based on market trends that can change on a dime with any single influencer. Thanks so much!
    Brian Burke Investor from Santa Rosa, CA
    Replied 5 months ago
    Exactly, Nina. IRR, CoC, and EM are the key performance metrics and should drive your strike price. You can't calculate IRR nor EM without knowing how much the property will sell for when it's time to sell--that's where cap rate comes in. Aside from that I find it pretty useless.
    Nathan Ownby Rental Property Investor from Murfreesboro, TN
    Replied 5 months ago
    Great article. I have long held the belief that real estate investors have been misunderstanding and misusing cap rate analysis. It’s merely a tool to compare competing income streams with varying purchase prices in guiding a purchase decision. Your third-to-last paragraph is spot on. Thanks for a great read.
    Brian Burke Investor from Santa Rosa, CA
    Replied 5 months ago
    Thanks for the comments, Nathan!
    Dennis Maynard Real Estate Broker from Los Angeles, CA
    Replied 5 months ago
    Brian, well put. Cap rates are not the panacea that people have been making them out to be. In fact, I have been warning people about even applying them to 2-4 unit properties, unless they understood what it is. I did have one instructor a few years ago who broke down the components of a cap rate into 2 parts, risk and expected return on investment (using a mortgage constant). While it was a fascinating way to look at it, the cap rate result never made sense in the LA market, so I tossed it... LOL. Good, job here.
    Brian Burke Investor from Santa Rosa, CA
    Replied 5 months ago
    Thanks Dennis! You're right about small properties. People should be looking at comps for 2-4 units, and gross rent multiplier can play a role here too, but not cap rate.
    Sonja Sevcik
    Replied 5 months ago
    Super points!
    Brian Burke Investor from Santa Rosa, CA
    Replied 5 months ago
    Thanks Sonja!
    Glen Campbell
    Replied 5 months ago
    A couple of points to highlight on cap rates: 1) Cap rates notoriously overestimate the run-rate cash flows on income property, particularly residential property. The usual culprit is repairs and maintenance. You need to estimate not only routine R&M (which a cap rate typically does capture), but also the cost of renovating suites (every 10-20 years or so). And in calculating your return, you should really also include allowances for replacing key building infrastructure over time (roof, HVAC, windows and doors, brick/siding, walkways, paving, common areas, etc.). For example, on my Toronto buildings, value per suite is about $300,000, rent per suite is about $1400/month. Typical cap rates cited by brokers would have an expense ratio of maybe 35% for NOI of $11,000 and a cap rate of 3.7%. But if you make a more conservative allowance for R&M, NOI would be more like $10,000 (cap rate of 3.3%); if you allow for capital replacements, cash flow is $7,000 - $8,000 per unit, or about 2.5%. 2) This overstatement of cap rates is part of the reason that prime buildings command lower cap rates. If you adjust both for the "missing" R&M and renovation cost allowances, the rates will be closer, because prime buildings have higher rental values per square foot. (The gap generally will not close fully, because non-prime buildings still have higher vacancy risk and, in many cases, more management headaches.)
    Brian Burke Investor from Santa Rosa, CA
    Replied 5 months ago
    You bring up a great point here, Glen. One of the biggest problems with cap rate, and one of the reasons I find it so useless, is that it is inconsistently calculated. Even looking through my old appraisal books and lender's underwriting models I find direct conflicts. Some appraisal books and lenders calculate cap rate with recurring capital expenditures (or the reserves for them) as part of the operating expenses. Others exclude it. I think the proper use of cap rate excludes recurring capital expenditures, and that's how I calculate my purchase cap rate when I buy. But when I'm underwriting my exit value I calculate the cap rate with the recurring capital expenditures included. It's the most conservative approach--I'm squeezing myself on both sides. But one thing is certain, the cost for replacements and recurring capital expenditures must be factored into the IRR and Equity Multiple calculations. I suspect that all too often it's left out.
    Thomas Psipsikas Rental Property Investor from Wantagh, NY
    Replied 5 months ago
    Those are such important points you made on variability. Unfortunately the inability to agree on a single, comprehensive definition of how something like cap rates work is all too common in most industries. Often times it is due to competition such as in the tech sector when different companies push standards that will benefit their business plan and products most. At the end of the day, it can keep viable technologies from inter-operating to serve the best possible use cases for customers. With cap rates, the somewhat (dare I say) insidious nature of it is that it is veiled as a common language while under the hood it is also a mess of competing interests, incompetence and subjectivity, mostly because as you noted, NOI is calculated inconsistently. To underscore points made by others regarding pro formas, you often see omissions that are either disingenuous or based on lack of knowledge. Either way it isn’t very helpful. Also, NOI depends heavily on which side of the purchase you are on. We want to believe Cap Rate and NOI are a common language and baseline to calculate value, but it really can’t be until (maybe) there is an industry wide definition or standard for what expense types must be calculated in the NOI to be a True Cap Rate. That said, most of us don’t really know what it costs to run a specific property until you own and operate it. Perhaps even more significant is that every operator has a different approach as to which expenses they deem are necessary and how much they pay for each. There isn’t a perfect solution to solve for all of this, but I would like to see at least a common industry wide consensus of what types of expenses must be included in an NOI/Cap Rate calculation based on the asset class. Those expenses also have variability that needs to be defined as well. For example, what’s our common language for NOI? Should it calculate current property tax rates, or factor in the more expensive one based on reassessing at the new sale price? -Are you a large operator who gets 4-5% property management rates or a new operator paying 8-10%+? -Does the current owner get preferred insurance rates because they own a lot of properties in the area while you cannot yet? This can clearly cause massive swings in expenses and therefore NOI/Cap Rates. If either of these change too much, you might see a swing of 1% or much more in the “true” cap rate. In a way, understanding cap rates needs to factor in what type of operator you are, but there doesn’t seem to be a viable apples-apples way to do this. It could disproportionately benefit the established operators with lower costs more than new investors….so new investors probably need to be even more mindful of these costs; especially in pro formas. Because of the potential variability in all this, it probably is a poor way to compare with others. It probably won’t match the pro forma or the local comps' cap rate. That seems okay as long as you understand the best ways to use Caps for exit projections as Brian said. To some degree there may be an argument that (maybe) you can use these inconsistencies to help in negotiations. If an accepted cap rate in an area is 6% and the OM also shows it at 6%, the agent and seller believe their price is competitive. You can then ask questions about how that cap rate was determined. Once you peel back the onion enough to show where they left out key expense costs, it will become apparent that their calculations would show a true cap rate of (let’s say) 5% and therefore no longer comps out. Of course that may not help too much in a seller’s market with multiple offers, but could in the near future. At the end of the day, so much of this is subjective and I agree not to place too much weight on cap rates in making purchasing decisions. Brian’s point about using other metrics of overall returns make so much sense for determining value. Cap Rates are an imperfect beast to use tactically as a rough guideline. It might be fun to compare all the different perceptions people have of what should be included in NOI’s to see how variable they truly can be.
    Brian Burke Investor from Santa Rosa, CA
    Replied 5 months ago
    Very, very true, Thomas! You are so right. It is for those reasons that using cap rate to determine a purchase price is an incorrect application of the concept, at best, and dangerous, at worst. In my acquisition model, I can calculate 36 different cap rates for the same acquisition price. But here is the right way to do it. Use trailing income, and actual trailing expenses (all of them except debt service and recurring capital improvements) and adjust the property taxes to the expected amount given any post-sale adjustments by the taxing jurisdiction. Don't let anyone else calculate it for you, you have to do it yourself by looking at the historical financials and the property tax rates. The best news is if you are wrong, and you underwrote the property properly (to investment performance, not cap rate), it won't even matter.
    Bernie Neyer Investor from Chanute, Kansas
    Replied 5 months ago
    I'm not nearly as big as you guys are, but this is an esoteric argument. I have to deal with a lot of different bankers to get the loans I need to purchase my properties, and to a banker, they want to know the cap rate. If I walked in with a cap rate of 3% they'd laugh me out of the bank. Now I don't live in those big fancy places where property is way over priced, but unless I can convince them the rent is way under market, the low Cap Rate indicates the property is over priced and the market pressure on that property is down. A banker won't loan on a property if it can become under collateralized, that's why many require a 70% - 75% LTV. Conversely, if I came in with a high Cap Rate of 20%, they would view with suspicion that there is something wrong with the property, or it would be selling for more. Ultimately I can throw the entire alphabet soup at them, IRR, ROI, etc., and it would mean nothing to them, unless that Cap Rate was where they it needed to be, because ultimately, the Cap Rate measures the ability of that property to support itself, and to spin off sufficient income to support the risk. Of course, like I said, I'm just a country boy and don't live in those big fancy places like you guys do, so I could be wrong.
    Brian Burke Investor from Santa Rosa, CA
    Replied 4 months ago
    It just sounds like you're talking to the wrong bankers, Bernie. Certainly any time you are buying far above or below market cap rates for the type of property you are buying in your area you'll have to have a good explanation. But lenders who "get it" will see past it if your story makes sense.
    Victoria Seale from Santa Fe, New Mexico
    Replied 5 months ago
    Thanks for your response Bernie!
    Josh Ott
    Replied 5 months ago
    I like your article, however I think its a bit unfair to bash so much on "Cap rate" at the beginning. It is a great tool to use in the correct way as you pointed out.
    Brian Burke Investor from Santa Rosa, CA
    Replied 5 months ago
    Indeed it is! It's really the only tool for estimating your exit. If I was unfairly harsh on cap rate, my message to cap rate is, I apologize. :)
    Ryan S. Rental Property Investor from Enterprise AL / Manhattan, KS
    Replied 5 months ago
    Great article! Thanks for posting!
    Brian Burke Investor from Santa Rosa, CA
    Replied 5 months ago
    Thanks for the comment! Glad you enjoyed it.
    Luis Rivera New to Real Estate from Puerto Rico
    Replied 5 months ago
    I have many questions but let me reread the article a couple of times!
    Gregory Delmonico Rental Property Investor from Louisville, KY
    Replied 5 months ago
    Thanks for the last 2 cap rate articles. Very informative! I like your definition of cap rates being about "market sentiment" and not necessarily performance.
    Brian Burke Investor from Santa Rosa, CA
    Replied 5 months ago
    That's all it is, Gregory. If only I could go back and re-write all of the textbooks...
    Ola Dantis Multifamily Syndicator from Houston, TX
    Replied 4 months ago
    What a great read! Cap rates are dynamistic in nature and using them as ONE measure to evaluate investment opportunities is a sure way to be blindsided. Thanks for writing this.
    Brian Burke Investor from Santa Rosa, CA
    Replied 4 months ago
    Thanks Ola!
    Tomer Versano Investor
    Replied 4 months ago
    Thanks for this, Brian. I always look for a high cap rate, though never really understood it fully. This helps shed a light on this mysterious factor haha
    Brian Burke Investor from Santa Rosa, CA
    Replied 4 months ago
    Now instead of looking for a high cap rate you know what to really look for! :)
    Brian Briscoe Rental Property Investor from Washington, DC
    Replied 4 months ago
    Thanks for the article -- very timely, especially with market sentiment being what it is...
    Brian Burke Investor from Santa Rosa, CA
    Replied 4 months ago
    Indeed, Brian. Thank you!
    Steve Morris Real Estate Broker from Portland, OR
    Replied 4 months ago
    Not crazy about reliance on CapRates based on reporting bias. That is, are they based on real numbers or proformas or the broker or the seller? Brokers are infamous for making dogs look like winners with pro formas. Other item is CapRates are a snapshot, one prop may be maxxed out and making great return. Whereas, you may be able to find a dog cheap that with some work can be an excellent return usually due to seller mis-management. Kinda like MPG in a car, you really want to pay $20K more for a hybrid version of a car when you won't make it back in 20 years of gas? What if you want to haul a lot of stuff? Point is, CapRates are but one measure and not real forward looking.
    Brian Burke Investor from Santa Rosa, CA
    Replied 4 months ago
    Exactly, Steve. In fact, they are not forward-looking at all. It is simply a measurement of historical income (adjusted for future taxes) divided by the purchase (or sale) price. Nothing forward-looking about that!
    David Duke Rental Property Investor from Kealakekua, HI
    Replied 4 months ago
    Great article. Thanks for clearing up some of the confusing elements of this concept.
    Brian Burke Investor from Santa Rosa, CA
    Replied 4 months ago
    Happy to do it, David!
    Jake Moran Rental Property Investor from Falls Church, VA
    Replied 4 months ago
    Brian, you're the man. You explain this stuff so clearly. One big question: HOW do you "follow those properties until learning the price they sell for"? Can you look at "recently solds" on Loopnet like you can on Zillow? Where can I find this information after properties are sold? ....Just did a google search and found this: https://www.loopnet.com/Apartment-Buildings-Sold/ So apparently you can find that info on Loopnet, it's just pretty well-hidden (as far as I can tell, there is no way to actually navigate to this page from Loopnet's main site!). Do you use any other/better methods for tracking recent sales? Thanks!
    Brian Burke Investor from Santa Rosa, CA
    Replied 4 months ago
    If you submitted an offer on the property, you could always call the broker after it closes and ask them. Or if you are engaged in the bidding you’ll have a pretty good idea where pricing was landing based on the pricing guidance you get at the late stage of the bidding. Some brokers can provide a list of recent sales showing all stuff that’s traded and at what price, so it might be on that list after closing. You could pull up the deed and reverse calculate the price using the transfer tax, or subscribe to a website like Reonomy, or get connected to research sites through your title company such as MyFirstAm from First American or Passport from Fidelity — you can only get those if you run a lot of business through the title company. Keep in mind that some states (like Texas) are non-disclosure states so the only way to find out is to ask the broker.
    Jake Moran Rental Property Investor from Falls Church, VA
    Replied 4 months ago
    That’s a lot of good tips, thanks!
    Jake Moran Rental Property Investor from Falls Church, VA
    Replied 4 months ago
    Shoot, as I take a closer look at this link, I realize it still it only lists properties that were recently listed but doesn't show the "sold" information... So any other tip you have would be much appreciated!
    Corbin Jones Rental Property Investor from Bridgewater, NJ
    Replied 4 months ago
    Thanks for the article! Do you have a link to a good resource that puts IRR in simple terms?
    Brian Burke Investor from Santa Rosa, CA
    Replied 4 months ago
    That's an article I haven't done yet, Corbin. Good idea though. I did what I think is a user-friendly write-up in my book The Hands-Off Investor. One of these days I'll write an article based on that chapter!