What is a cap rate and how do I calculate it?

A cap rate, short for capitalization rate, is a property's annual net operating income divided by its price, shown as a percentage. It measures what a property earns in a year relative to what it costs, giving you a quick way to compare income-producing properties. A higher cap rate generally means a higher income relative to the price.

The cap rate answers a simple question: if you bought the property in cash, what annual return would the income alone produce? It is the first screen many investors use.

Divide the net operating income by the property value, then multiply by 100 to get the percentage. Net operating income is the rental income minus operating expenses, before the mortgage payment. For example, a property with $20,000 in net operating income and a $250,000 price has a cap rate of 8 percent.

The formula is simple, but the inputs matter: use realistic income and complete operating expenses, including vacancy, taxes, insurance, and maintenance. Skimping on expenses inflates the cap rate and the appeal of the deal.

Cap rates are a quick screen for comparing deals, but they leave taxes and appreciation out. Because the cap rate ignores the mortgage, it compares properties as if bought in cash, which is useful for apples-to-apples comparison but not the full picture of a financed investment. It also ignores the return from appreciation and principal paydown.

Cap rates also reflect the market: in competitive, lower-risk areas, cap rates tend to be lower, while higher-risk or lower-demand areas show higher cap rates. Compare properties in similar areas, since a cap rate that is great in one neighborhood is mediocre in another.

Use the cap rate as one tool alongside cash flow, cash-on-cash return, and the total return including appreciation. A property with a modest cap rate can still be a great investment if it appreciates strongly, and a high cap rate can hide high expenses or vacancy risk. The cap rate opens the analysis; the other measures complete it.

Build a full underwriting for any property you seriously consider: the cap rate, the monthly cash flow with your actual financing, and the projected long-term return. The deal that works on all of them is the one worth pursuing.