The yield the market uses to value a building
A cap rate answers a simple question: if you paid all cash for this property, what annual return would its income produce? You take thenet operating income— the rent left after vacancy and operating expenses, but before any mortgage — and divide it by the price. Because the mortgage is left out, the cap rate describes the building on its own merits, not the financing you arranged. That is precisely why it has become the common currency of commercial real estate: two investors with completely different loans can still compare the same deal on identical terms.
The cap rate formula
Cap rate = Net operating income ÷ Property value
Value = Net operating income ÷ Cap rate
where net operating income is income after vacancy and operating costs but before debt service. Rearranged, the same relationship turns a cap rate into a value — the engine behind how income property is priced.
Worked example
Take a rental property priced at $500,000 that produces $39,000 of net operating income a year. Here is how the cap rate falls out:
| Step | Amount |
|---|---|
| Net operating incomeannual rent after vacancy and operating expenses, before any mortgage | $39,000 |
| ÷ Property value | $500,000 |
| Price per $1 of NOIthe value divided by the income — the multiple buyers are paying | 12.82× |
| = Cap ratethe unlevered annual yield if you bought the building in cash | 7.80% |
Computed with this calculator's default settings — open the tool above and you'll see the same numbers, then swap in your own property's income and price.
Why a lower cap rate means a higher price
The two readings of the formula are inseparable. Read one way, a price gives you a yield; read the other, a yield gives you a price. For a fixed income, those move in opposite directions — a lower cap rate produces a higher value, and a higher cap rate a lower one. So when a market is hot or its income is seen as safe, buyers accept a lower cap rate and prices rise; when a market is riskier, buyers demand a higher cap rate and pay less per dollar of income. Investors use this to value a building from comparable sales and to compare entire markets at a glance: a 4 percent city and an 8 percent city are pricing the same dollar of rent very differently.
Typical cap rates vary widely by market, property type, and the moment in the cycle, so there is no universal “good” number — a figure that signals a bargain in one market would look aggressive in another. The right comparison is always against similar properties nearby, not an absolute target.
What the cap rate does not capture
- Financing and leverage. The cap rate is unlevered by design, so it says nothing about your mortgage. For the return on the cash you actually invest after debt service, use thecash-on-cash return calculator, the levered counterpart to the cap rate.
- Appreciation. A cap rate is a snapshot of current income, not a forecast. It ignores any gain (or loss) in the property’s value over time, which can dominate the total return.
- Capital expenditure. Big-ticket items like a new roof or HVAC sit outside operating expenses, so two buildings with the same cap rate can have very different real cash needs.
- Your tax situation. Depreciation, interest deductions, and your own bracket all change the after-tax outcome, none of which the cap rate reflects.
For an even faster first-pass screen that skips expenses entirely, thegross rent multiplier calculatorcompares price to gross rent — useful for shortlisting before you run the full cap rate on the contenders.
Frequently asked questions
What is a cap rate?
The capitalization rate is a property’s annual net operating income expressed as a percentage of its value or purchase price. It is the unlevered yield — the return you would earn if you bought the building outright in cash, with no mortgage involved. Because it strips out financing, it measures the property itself rather than how you happen to pay for it, which makes it the common language investors use to compare income-producing real estate.
How do you calculate cap rate?
Divide the net operating income by the property value or price, then express the result as a percentage. Net operating income is the rent collected after vacancy, less operating expenses such as taxes, insurance, management, and maintenance — but before any mortgage payment. For example, a building producing 60,000 dollars of net operating income at a price of 1,000,000 dollars has a cap rate of 6 percent. The same formula rearranges to value: value equals net operating income divided by the cap rate.
What is a good cap rate?
There is no single good number — a cap rate is only meaningful relative to its market and asset class. A stabilized apartment building in a prime coastal city might trade at a low cap rate because demand is high and the income is seen as safe, while a strip mall in a smaller market might command a much higher cap rate to compensate for greater risk. A lower cap rate means a higher price and usually a hotter or safer market; a higher cap rate means a cheaper price and often more risk. Judge a cap rate against comparable properties, not an absolute target.
Does cap rate include the mortgage?
No. The cap rate is deliberately unlevered: it uses net operating income, which is calculated before any debt service, so the mortgage plays no part in it. This is what lets two investors with very different financing compare the same building on equal footing. To measure the return on the actual cash you put in after the mortgage is paid, you need cash-on-cash return instead, which is the levered counterpart to the cap rate.
How do cap rate and value relate?
They are inversely linked through the formula value equals net operating income divided by cap rate. For a fixed income, a lower cap rate produces a higher value and a higher cap rate produces a lower value. This is why investors talk about cap rate compression driving prices up: when buyers accept a lower cap rate, they are paying more for each dollar of income. Knowing a market’s prevailing cap rate lets you turn a property’s net operating income straight into an estimated value.
Disclaimer: This calculator is foreducation and illustration only. A cap rate rests on a single year’s net operating income and a single assumed value, and the figures it produces are not appraisals of any specific property. Nothing here is investment, tax, or real-estate advice.