What Is Cap Rate?
Also known as: Capitalization Rate
Divide a rental property’s annual net operating income by its price or value, and the resulting ratio is the cap rate. It measures the property’s income yield with financing stripped out, which makes it a common yardstick for comparing income properties.
Divide a rental property’s annual net operating income by its price or value, and the resulting ratio is the cap rate. It measures the property’s income yield with financing stripped out, which makes it a common yardstick for comparing income properties.
Cap Rate explained
Net operating income, or NOI, is what a property earns in a year after vacancy and operating expenses, but before any mortgage payment. Expenses usually cover property taxes, insurance, repairs, management, and utilities the owner pays. Debt service and depreciation stay out on purpose, so two buyers with different loans see the same cap rate on the same building. A higher figure means more income per unit of price and often more risk. Reverse the formula and it prices a deal: divide the NOI by the yield a buyer wants and you get the most they should pay.
On the disposition side, cap rate matters when a wholesaler pitches a duplex, fourplex, or small apartment building to landlords, because those buyers work backward from rent. The dispo manager needs the rent roll, a realistic expense picture, and the going cap rate for similar buildings nearby before the deal goes out. On the acquisition side it explains why a tired landlord expects a number tied to income, not a single-family comp. Callers should capture occupancy, what tenants pay, and who covers utilities.
The weak link is the NOI. Sellers tend to quote asking rents instead of collected rents, skip vacancy, and leave out management and repairs, which inflates the result. Property taxes can also reset after a sale. A building that needs heavy rehab has a misleading cap rate until repair cost is added to the price, and because the figure ignores financing it should sit beside cash-on-cash return. Compare it only against buildings of similar type, condition, and location.
Example
A wholesaler has a fourplex under contract and is pitching it to rental buyers. A buyer runs the building’s collected rents less taxes, insurance, repairs, and management, divides that income by the contract price, and compares the result with what similar fourplexes in the area have been selling at. The yield comes out below the local norm, so the buyer asks for a lower price rather than walking away.
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