An Investor Answers: Why Does the Cap Rate Formula Not Include Debt Service?


There was a period of time when writing became cumbersome. I felt I’d written so much that there was nothing more I could add.

And then I was reminded that writing, as much as I happen to enjoy it, is nonetheless not about me — it’s about you, and as long as you have questions, I will never run out of things to write about. And guess what? The questions just never stop. So, here we go.

The Question That Came in Yesterday

I am really busy nowadays since I am preparing my house and some of the apartments for the market as part of relocating my family to Arizona, where the weather is so much better than in Ohio, and my buddy Serge S. and I will be so bored on the golf courses together. Being busy means I don’t open the email as often as I’d like. However, whenever I do, the questions are always there.

Yesterday the question was posed:

Why do we not include debt service into the cap rate? After all, if the cap rate is supposed to measure the rate of return on the investment, and debt service obviously goes against the cash flow, why not include it?

Related: How to Know What Cap Rate to Shoot For on Any Given Rental Property

Good question, so let’s talk about it.


What is Cap Rate?

This is huge, guys, so pay attention!

Capitalization rate is not a metric of investment return on a specific investment. Cap rate is a market-driven metric, which measure the attitude and behavior of all market participants. Think of it this way:

In the SFR world, in order to estimate valuation of property, we do something called comparative market analysis — CMA for short. What CMA does is it looks at like properties that closed and makes adjustments to all of those “comps” to guesstimate what the value of subject may be. In the SFR world, there is no mention of income in the value-setting mechanics. All we do with CMA — and by “we,” I mean banks and appraisers — is consider what people have been willing to pay for SFR and then discount or inflate based on amenities to arrive at likely value of the subject.

This is pretty straightforward. Because these houses are designed not as income assets but as shelters, the appraising mechanics make no mention of anything having to do with income.

Income Property

At least in its most basic form, income property is purchased for its income, which means that the value of the property is in some way pegged on its income. And because this is so, simply looking at the sales price of a comp tells us nothing. What we really want to know is how this sales prices was pegged to the income — we are interested in that relationship between the income and the price.

This relationship, when represented with a coefficient, is the CPA rate. So, if we are able to analyze the income of an asset and juxtapose it to what someone paid for the property, we can arrive at a representation of how much they thought the income was worth, in this asset class, in this marketplace.

For example, if you know that some paid $100,000 for a 4-plex, and you know that said 4-plex generated $10,000 of income, then you know that the buyer was looking for a 10% return — $10,000 is 10% $100,000.

What Income?

In the above example, when I say “income,” what I really mean is net operating income — NOI. The NOI is what’s left of gross potential income after the economic losses and all other operating expenses (OpEx).

Related: Cap Rate: How to Best Evaluate & Interpret a Property’s Numbers

Important to note is that OpEx does not include debt service!


Why Not?

Simple, if you think about it. The debt service is a function of the financing structure in the deal. One person may pay cash, in which case he would not have any debt service, while someone else may finance 100 percent — and everything in between.

As such, the debt service is personalized to the investor and is not an asset-specific cost. And in that we want to compare apples to apples, we only focus on OpEx, which in equal measure applies to all potential buyers.

Cash Flow

Of course, the debt service, whenever there is debt, must be subtracted from the NOI in order to arrive at the cash flow. And to calculate investment returns relative to your cash investment, you must use either COC or IRR, of which IRR is much more dynamic.


Cap rate is not a metric of return on a specific asset. Cap rate illustrates how the marketplace as a whole values income!

Investors: Have any questions about how these calculations work?

Leave a comment, and let’s talk.

About Author

Ben Leybovich

Ben Leybovich has been investing in multifamily residential real estate since 2006. His area of expertise is creative finance. Ben works extensively with private as well as institutional financing. Ben is a licensed Realtor with YOCUM Realty in Lima, Ohio. He is also the author of Cash Flow Freedom University and creator of a cash flow analysis software CFFU Cash Flow Analyzer.


  1. Mike McKinzie

    Well written Ben. You should enjoy Arizona, I am heading to the Kingman area Thursday, supposed to hit 117 on Friday. As for financing, any time you finance ANYTHING, you do not add the cost of the finance to the cost of the item. The mortgage interest is the cost of the MONEY, not the cost of the investment. Plus, look at the other side. If you bought a note, the Cap Rate on the house is of no consequence to you. That is why there are at least a dozen different, IMPORTANT numbers to know when buying a Real Estate Investment. For instance, a 10 year old house that cost $150,000 to buy and rents for $1,500 a month in Tulsa, OK may be a good investments while a nearly identical house that cost $150,000 and rents for $1,500 a month may be a poor investment in Dallas, TX. Or vice versa.

  2. David Faulkner

    Spot on with this definition and description of uses IMO.

    A bit off topic, but congrats on your move to AZ, Ben. You surely won’t freeze during the winter, but may burn you A$$ in the summer 🙂 You going to join forces on the golf course and in MF syndication in Phoenix with your good buddy Serge, or try to hit that next tech wave by moving down to Tucson where they have a real technical university (UA engineering alumni here, so may be a bit biased) and an independent techno hippie vibe that attracts those kind of companies?

      • David Faulkner

        Nailed it… LOL. Out of Ohio at the peak, move to AZ to familiarize yourself with the market just in time to get back in at the bottom a few years later. The next peak after that you will probably move to CA where you will neither freeze in the winter nor burn in the summer and spend the rest of your days having Burke beat you on the golf course. I know what you are going to do before even you do, Ben 🙂 Seriously, though, congrats …. you are playing the game like the champ that you are!

  3. So the loan is not specific to the property? Not entirely…. On low end properties in bad neighborhoods, you will find that you can’t get a “good” loan, because the “good” banks have redlined the area. They’re not supposed to, but they do. So you have to take a higher interest rate into account in your analysis.

    Maybe the asset supports the higher rate…. after all, stuff in bad areas sell cheap, right?
    OTOH, if the banks won’t loan, you have to ask yourself – are you really smarter than the
    bank? Maybe there’s a reason.

  4. Justin R.

    If the financing terms available to participants in a market improve, it’s likely that CAP rates in that market would compress … I suppose in that sense you could say that CAP rates in a market are influenced by financing terms. But Ben’s point was simply that CAP Rate is not a measure of a specific property’s performance.

    Re: the link you posted… Would you agree that the author’s purpose was to explain how an individual borrower’s available financing determines the CAP rate at which s/he should shop?

    • That’s not the essence of his conclusion. CAP is not about the market, but about the available financing for a specific property and specific borrower. Different borrowers and different properties will qualify for different cost and structure of financing. Thus, different CAP rates.

      • Justin R.

        Imagine two identical properties with the same NOI – one in market X and another in market Y – and an investor who has identical financing available for either property. Would you agree that the investor may value more (and, hence, pay more for) one property than the other?

      • Ben Leybovich

        Guys – you’re splitting hairs. Of course, at the market level, the easier and less expensive it is to achieve leverage, the higher Caps will go. This is what’s been happening in a lot of markets. However, for the purpose of this article, this just proves the point – Cap rate is a metric of market behavior, and availability of financing is but one element impacting the behavior of market participants 🙂

  5. Michael Dake

    Another great post, Ben. What role should or does CAP rate play in the appraisal process for investment properties? When buying shelter, as you put it (jealous), value is determined by CMA all the way. But when buying cash flow, risk tolerance is part of the assessment. How or should an appraisal take that into consideration?

  6. The availability of credit does impact values and this is how the Fed impacts the economy as a whole. The easier credit is to obtain, the higher overall prices go, or Cap Rates compress. As credit tightens, then values fall or Cap Rates increase. But to say that Caps have nothing to do with market sentiment or perceived value, well that’s just wrong. Like Ben said, financing is just one of many factors at play in the market place. We live in a credit based economy and it’s the gas that keeps us going or eventually burns us all when over extended.

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