Capitalization rate — cap rate — is the first number buyers, sellers, brokers, and lenders quote when sizing up an income property. It captures the property’s yield before any financing enters the picture, which makes it a clean, apples-to-apples comparison tool across markets, property types, and deal structures.
The formula is simple. The inputs are not — specifically NOI, which most investors calculate incorrectly. Here is the formula, how to build the NOI number underneath it, what the result tells you, and what it misses entirely.
NOI = Net Operating Income. Purchase Price = total acquisition cost. Cap rate expresses how many cents per dollar the property earns before financing. At a 6% cap rate, each $100 of purchase price earns $6.00 of annual income, unlevered.
Effective Gross Income = Gross Rents − Vacancy. Operating expenses include property taxes, insurance, maintenance, property management fees, and capital reserves. What they do not include: mortgage payments, depreciation, or income taxes. NOI is a pre-financing, pre-tax number.
A $300,000 single-family rental. Monthly rent of $2,500. Here is the full NOI build, line by line.
| Line Item | Annual Amount |
|---|---|
| Income | |
| Gross Rental Income | $30,000 |
| Vacancy (5%) | −$1,500 |
| Effective Gross Income (EGI) | $28,500 |
| Operating Expenses | |
| Property Taxes | $4,500 |
| Insurance | $1,500 |
| Maintenance & Repairs | $2,500 |
| Property Management (8% of EGI) | $2,280 |
| Capital Reserves | $1,220 |
| Total Operating Expenses | $12,000 |
| Net Operating Income (NOI) | $16,500 |
| Cap Rate ($16,500 ÷ $300,000) | 5.5% |
A 5.5% cap rate means this property yields $5.50 per year for every $100 of its purchase price, before any mortgage payment is considered. Whether that is a good number depends on the market.
Where most cap rate calculations go wrong: Investors frequently omit capital reserves and property management from their expense stack — often because they self-manage and don’t plan to set aside reserves. If you skip those two lines on this property: NOI rises to $20,000 and the calculated cap rate is 6.7% instead of 5.5%. The property has not changed. The analysis is just wrong. Use a fully loaded expense stack even if you plan to self-manage — it reflects the economic reality of ownership, not your current intentions.
There is no single threshold for a “good” cap rate. The right benchmark depends on property class, market, and property type.
| Property / Market Type | Typical Cap Rate Range | What Drives the Range |
|---|---|---|
| Class A SFR / multifamily, primary market | 4.0–5.5% | Low risk, strong appreciation prospects, deep buyer pool |
| Class B SFR / small multifamily, secondary market | 5.5–7.0% | Moderate risk, less institutional competition, decent appreciation |
| Class C / higher-yield residential, tertiary market | 7.0–9.0% | Higher risk and vacancy, less appreciation, income-driven |
| Small multifamily (2–4 units) | 5.0–7.0% | Scales with local SFR market but with some density premium |
| Larger multifamily (5+ units) | 4.5–6.5% | Institutional demand compresses yields; rent growth offsets thin yields |
The practical takeaway: a 5.5% cap rate on a Class A property in a competitive market is solid. The same 5.5% cap rate on a Class C property in a tertiary market is thin — you are not being compensated enough for the additional risk.
Cap rate works in reverse: if you know the NOI and the market cap rate for comparable properties, you can estimate what a buyer should pay.
Divide the property’s NOI by the cap rate that comparable properties trade at in that market. The result is the indicated market value — the price at which this property should trade to match the market yield.
Using our example: NOI = $16,500. The market for comparable properties is 5.5% cap rates. Indicated value = $16,500 ÷ 0.055 = $300,000. That is what the property is worth based on its income.
Now run the same NOI at 7.0% — what would happen to value if the market shifted and buyers demanded higher yields?
| Scenario | NOI | Cap Rate | Indicated Value |
|---|---|---|---|
| Current market | $16,500 | 5.5% | $300,000 |
| Cap rate expansion (+1.5%) | $16,500 | 7.0% | $235,714 |
| Value change | — | — | −$64,286 (−21%) |
Same property. Same NOI. A 1.5-percentage-point expansion in cap rates — the kind of move that happened broadly between 2021 and 2023 — erases 21% of value without the property itself changing at all. This is why buyers who underwrote deals at 4% cap rates in 2021 saw paper losses even as their properties continued to generate the same income.
Use the reverse formula as a discipline: before making an offer, decide the minimum cap rate you will accept. Divide the property’s NOI by that rate. The result is the most you should pay.
If you require a 7% cap rate on this property with $16,500 NOI: $16,500 ÷ 0.07 = $235,714. That is your walk-away number. If the ask is $300,000, you are either renegotiating or walking away.
Cap rates reflect the risk-adjusted yield investors require for real estate relative to alternatives. Two primary forces:
Practically: in a 7%+ mortgage rate environment, be cautious about acquiring properties at sub-5% cap rates unless you have a specific rent-growth thesis backed by local supply/demand data. The math of negative leverage compounds against you if the appreciation bet does not materialize.
Cap rate is a useful entry-level metric, but it has real blind spots:
For a metric that incorporates appreciation, financing, and the timing of all cash flows over your hold period, use IRR. For lender qualification, use DSCR. Cap rate is where the analysis starts, not where it ends.
These three metrics answer different questions. Use them in this order:
The three-filter rule: A deal that clears all three checks — reasonable cap rate for the market, DSCR ≥ 1.25x, and CoC above your floor — is a deal worth modeling in depth. One that fails any of the three needs renegotiation before you spend more time on it.
The Deal Analyzer builds your NOI from inputs, calculates all four metrics, runs sensitivity tables, and gives you a GO/NO-GO verdict. Includes Lender Solver to back-calculate maximum purchase price at any cap rate target. Lite $9 / Pro $29.
Get Lite — $9 See Pro — $29What is a good cap rate for rental property in 2026?
It depends on property class and market. Class A suburban SFRs in primary markets typically trade at 4–5.5% — buyers accept thinner yields for lower risk and appreciation prospects. Class B properties in secondary markets run 5.5–7%. Class C and higher-yield properties reach 7–9%. A 5.5–6.5% cap rate on a well-located rental in a solid secondary market is healthy in 2026. Below 4% in most markets means appreciation is doing the heavy lifting — that is a bet, not an income return.
What is the difference between cap rate and cash on cash return?
Cap rate measures the property’s unlevered return — NOI divided by purchase price, ignoring financing. Cash on cash return measures your equity’s levered return — annual pre-tax cash flow after debt service divided by total cash invested. With an all-cash purchase, they are equal. With a mortgage, they diverge based on whether the cap rate exceeds the mortgage constant. In a 7%+ rate environment, most leveraged deals produce a CoC below the cap rate — a condition called dilutive leverage.
How do you use cap rate to value a property?
Divide the property’s NOI by the cap rate that comparable properties trade at in that market: Value = NOI ÷ Cap Rate. If comparables trade at 6% and the property generates $18,000 NOI, the indicated value is $300,000. Run it in reverse to find your maximum offer: if you require a 7% cap rate on that same $18,000 NOI, your maximum price is $257,143. This is called direct capitalization and is the standard method appraisers and lenders use to value income property.
What causes cap rates to rise or fall?
Cap rates move with the risk premium investors require relative to other investments. When interest rates rise, buyers need higher yields to justify real estate over Treasuries — cap rates expand and values fall for the same NOI. When rent growth is strong and supply is constrained, investors accept lower yields because they are pricing future NOI growth — cap rates compress and values rise. The 2022–2023 rate-hiking cycle pushed cap rates up significantly; markets that had compressed to 3–4% cap rates saw meaningful value corrections even as properties continued generating income.