What cap rate actually measures
The capitalization rate is real estate's answer to a stock's earnings yield: one number that prices the income an asset produces against what it costs to buy. If a rental generates $30,000 of annual net operating income and sells for $500,000, the cap rate is 6% — the first year's unlevered return on the purchase price, expressed the way the whole industry compares deals. Mortgage-free, appreciation-free, opinion-free.
That stripping-away is the feature. Sellers' listing sheets flatter properties with pro-forma rents and forgotten roofs; cap rate forces the conversation onto actual income versus actual price. When two buildings in the same neighborhood show a percentage-point gap, either one is mispriced or there is a reason — deferred maintenance, a bad tenant, a declining block — worth finding before you write an offer.
The formula, explained honestly
cap rate = net operating income ÷ price
Net operating income starts with gross scheduled rent, subtracts a realistic vacancy allowance, then subtracts operating expenses: property taxes, insurance, maintenance, management, HOA, owner-paid utilities. Two deliberate exclusions define the number:
- Debt service stays out. Your mortgage is a financing decision, not a property fact. Excluding it is what makes cap rates comparable across buyers and deals.
- Capital reserves stay out — so add them back mentally. Roofs and furnaces die on a schedule. NOI without a reserve for capex overstates the true yield by a point or more, which is the most common way optimistic investors fool themselves.
The calculator divides your honest NOI by the price, then runs the division backwards too: enter a target cap rate and it tells you the price that NOI supports — the value at cap — which turns the tool from a grader into a bidding discipline.
A worked example
A duplex lists for $430,000. Each unit rents at $1,500/month — $36,000 of gross annual income. Annual operating expenses: $4,200 property tax, $1,800 insurance, $2,400 maintenance, $2,880 management (8%), and 5% vacancy ($1,800) totals $13,080.
- NOI = $36,000 − $13,080 = $22,920.
- Cap rate at asking = $22,920 ÷ $430,000 = 5.3% — below the 6% at which comparable duplexes nearby trade.
- Value at your 6% target: $22,920 ÷ 0.06 = $382,000. To pay asking and still hit 6%, NOI must rise to $25,800 — about $120 more per unit per month.
- Now the financing question the cap rate can't answer: at 7% mortgage rates and 25% down, that 5.3% cap runs negative cash flow. The deal only works with an appreciation thesis — a bet, not a yield.
Reading your verdict
The panel states your cap rate and translates it: under ~3% is appreciation speculation; 3–6% is mainstream in premium markets; above ~6% is real yield that leverage can work with, usually paid for in tenant turnover risk or location. If the rate comes back negative, the building loses money before the bank even gets paid — walk. One more frame for FIRE investors: a cap rate is an income-property withdrawal rate with a side of repairs, which is why it should be compared against the 4 percent rule's assumptions, not confused with it — paper portfolios don't need new water heaters.
Frequently asked questions
What is a good cap rate?
Context decides. Stable Midwest rentals commonly trade at 6–10% cap rates; West Coast and Northeast gateway markets sit at 3–5% because buyers pay for appreciation and rent growth, not current yield. The honest comparison is against the risk-free alternative: a 5.5% Treasury takes zero effort and zero vacancy risk, so a property needs a meaningfully higher cap to compensate. Judge each cap rate against local comps, not a national average.
Why is the mortgage payment excluded from cap rate?
On purpose. Cap rate measures the property's unlevered yield — the asset itself — while your loan is a personal financing choice layered on top. Two buyers paying different down payments get wildly different cash flow on the identical building, but the cap rate stays the same, which is exactly what makes it comparable between properties. For your leveraged return, compare cash-on-cash return instead: annual cash flow after debt service ÷ cash invested.
What expenses count in NOI?
Everything it costs to operate the property for a year: property taxes, insurance, maintenance and repairs, property management fees, HOA dues, utilities you pay, and a vacancy allowance for lost rent. What stays out: the mortgage (principal and interest), capital expenditures like a roof replacement, and one-time closing costs. Owners who forget reserves routinely overstate NOI by 1–2 full points of cap rate.
How do I use cap rate to value a property?
Invert it: value = NOI ÷ target cap rate. If a property throws off $32,000 of NOI and similar buildings trade at 6% caps, market value is roughly $533,000. The calculator does this reverse mode for you — enter your NOI and the yield you demand, and it tells you the most you can pay. Bidding wars and low inventory are not a reason to accept a 3% cap when your market prices risk at 6%.
Is cap rate the same as my return on investment?
No — it is a valuation snapshot, not your personal return. Cap rate ignores financing (leverage amplifies returns and risk), appreciation, tax benefits like depreciation, and capital expenditures. A 6% cap financed at 5% with 25% down can produce a double-digit cash-on-cash return; the same property can also be a cash-flow disaster after a new roof. Use cap rate to compare properties; use cash flow projections to decide on one.
Related calculators
Compare the yield against paper-portfolio withdrawals on the 4 percent rule calculator, size the target it feeds on the FIRE number calculator, and track the monthly fuel on the savings rate calculator — all on the FireVerdict hub.