What a cap rate measures
A cap rate is one year of net operating income divided by the property's price or value: the "free and clear" return before any financing.[2] Its inverse is the price paid for each dollar of NOI: a 5% cap rate means paying $20 for every $1 of yearly NOI, and a 10% cap rate means paying $10.[2]
Because it is a price relationship, a cap rate is not a full rate of return.[2] It leaves out the loan, future changes in rent and value, and what you get back when you sell. Use the cap rate calculator to work out the number itself.
Why no cap rate is good everywhere
A cap rate is "good" only relative to the risk and growth that come with the income. Buyers accept a lower cap rate when they expect the income to grow or to be safer, and demand a higher one when they expect it to shrink or to be harder to collect. When income is expected to grow, the investor's required return is normally above the cap rate.[1]
| A lower cap rate usually means buyers expect… | A higher cap rate usually means buyers expect… |
|---|---|
| Rents to rise faster | Rents to grow slowly or fall |
| Steadier occupancy and collections | More vacancy, turnover or bad debt |
| Fewer big repairs soon | An older building with capital needs |
| Easier resale | A thinner market of buyers |
So a 9% cap rate is not automatically better than a 5% one. The higher figure may simply be the market's price for more risk. Every investment carries some risk, and higher expected income is usually the compensation for it.[6]
Test 1: compare with comparable sales
The market cap rate comes from recent sales of similar properties: divide each one's NOI by its sale price.[1] If similar buildings nearby sold at around 6% and a seller asks a price that implies 7%, either the property is cheap or the NOI is overstated. The second is more common, which is why test 3 matters.
Comparables must really be comparable: same property type, similar age and condition, same area, recent sales. A cap rate from a different city or a different year says little about this property. To turn a market cap rate into a value, use the rental property value calculator.
Test 2: compare with your loan constant
If you borrow, the cap rate has to beat the loan's annual cost for leverage to help. That cost is the loan constant: a year of payments divided by the loan amount, which is always above the interest rate because it includes principal.[3]
| Interest rate | Loan constant | Break-even cap rate at 75% LTV |
|---|---|---|
| 5% | 6.44% | 4.83% |
| 6% | 7.19% | 5.40% |
| 6.5% | 7.58% | 5.69% |
| 7% | 7.98% | 5.99% |
| 7.5% | 8.39% | 6.29% |
| 8% | 8.81% | 6.60% |
At 7% interest and 75% loan-to-value, a property needs a cap rate of about 5.99% just for NOI to cover the payment. At that cap rate the cash-on-cash return is zero; below it, you pay to own the property. The cash-on-cash return calculator shows the effect for any loan. Investment-property loans also have lower loan-to-value limits than owner-occupied loans (85% for a one-unit purchase at Fannie Mae), which caps how much leverage you can use.[5]
Test 3: recalculate with a lender-style NOI
A cap rate is only as good as the NOI behind it. Seller statements often leave out management, reserves or a tax reassessment. Agency lenders apply minimums instead, for example at least 5% of gross potential rent for vacancy and bad debt, at least 3% of income for management, taxes at no less than last year's bill plus 3%, and a replacement reserve of at least $200 per unit per year.[4] Rebuild the NOI with those floors on the NOI calculator and divide again. If the cap rate falls from 7% to 5.8%, the 5.8% is the figure to judge.
Why this site does not publish "average cap rates"
We did not find a government, agency or university source that publishes current cap rates by market, and private surveys differ in method and coverage. A national or city average also hides the differences that matter most: property type, age, condition and street. Recent comparable sales, run through the three tests above, are a better guide than any average. In California, also recompute each comparable with the tax a buyer pays after Prop 13 reassessment; the California cap rate calculator does that.
Bottom lineA good cap rate is one that holds up after a conservative NOI, sits in line with comparable sales, and exceeds your loan constant by enough to leave a cushion. Check the full picture on the rental property calculator.
Frequently asked questions
Is a higher cap rate better?
Not necessarily. A higher cap rate means more income per dollar of price, but it often reflects more risk, slower growth or a building that needs work.
Is a 5% cap rate good?
It can be, if comparable properties trade near 5% and the income is secure and growing. With a loan, though, a 5% cap rate is below most loan constants, so borrowing would reduce the cash return.
Is a 10% cap rate good?
It is high income for the price, which usually comes with higher risk. Check that the NOI is realistic and find out why the market prices the property that way.
What cap rate do I need for positive cash flow?
More than your loan-to-value times your loan constant. At 75% LTV and a 7%, 30-year loan, that is roughly 6%.
Sources
- Etter, W. E. Direct Capitalization Versus Discounted Cash Flow Analysis (Publication 1051)
- Etter, W. E. Expected Rate of Return: More than Interest (Publication 1145)
- Etter, W. E. Calculating Mortgage Loans (Publication 923)
- 203.01 Underwritten Net Cash Flow (Multifamily Selling and Servicing Guide, Part II, Ch. 2)
- Eligibility Matrix
- What is Risk?