Cap Rate Guide: How Real Estate Investors Value Income Property
How cap rate works as a yield metric, what counts as net operating income, why cap rates compress in hot markets, and where it falls short.
Cap rate in one sentence
Capitalization rate is annual net operating income divided by property value, expressed as a percentage. A property generating $70,000 of NOI on a $1,000,000 value has a 7% cap rate. It's the yield you'd earn if you bought the property all-cash.
The formula
Cap Rate = Net Operating Income ÷ Property Value
NOI is rent collected (after vacancy) minus all operating expenses except debt service and capital expenditure. That's the deliberate choice — cap rate is meant to be a financing-agnostic measure of the property's earning power.
What counts as NOI — and what doesn't
NOI includes: gross rent (net of vacancy), other income (laundry, parking, pet rent, late fees), minus property taxes, insurance, property management, utilities (if landlord-paid), routine maintenance, leasing costs, and HOA dues.
NOI excludes: mortgage payments, principal payments, capital improvements (roof, HVAC, kitchens), depreciation, and income taxes. This is critical — cap rate doesn't care how you finance the deal.
Market cap rates and what they mean
Cap rates vary by market, asset class, and economic conditions. As a rough modern (2025–2026) baseline:
- Class A multifamily in top US metros: 4.5%–5.5%
- Class B multifamily in secondary markets: 5.5%–6.5%
- Class C / value-add multifamily: 6.5%–8%
- Suburban office and retail: 6.5%–8.5%
- Self-storage: 5.5%–7%
- Industrial/warehouse: 5%–6.5%
A 4% cap rate signals investors are bidding aggressively because they expect rent growth or appreciation. An 8% cap rate signals the market wants more current yield to compensate for risk. Neither is intrinsically 'better' — they reflect different bets on different markets.
Cap rate compression and decompression
When investors get bullish and bid up prices faster than NOI grows, cap rates fall. This is 'compression.' When investor confidence falls and prices drop faster than NOI, cap rates rise. This is 'decompression' or 'expansion.'
The 2010–2021 bull market saw substantial cap rate compression across most commercial real estate. The 2022–2024 rate-hike cycle reversed much of that. Buying during decompression often means lower entry prices and stronger forward returns.
Using cap rate to value a property
If you know the market cap rate and the property's NOI, you can estimate its value: Value = NOI ÷ Cap Rate.
A 16-unit apartment building with $200,000 of stabilized NOI in a market trading at 6% caps is worth roughly $200,000 ÷ 0.06 = $3.33M. Brokers and appraisers use this triangulation constantly. The number is only as good as the NOI and the cap rate you use — both are debatable.
Where cap rate falls short
Cap rate ignores leverage entirely. A property with a 6% cap rate financed at 7% is destroying cash flow, while a 6% cap with a 4% loan is generating positive leverage. Cash-on-cash return and IRR are better metrics for leveraged investments.
Cap rate uses current NOI. A property with $200,000 NOI that's underrented may grow to $250,000 in two years. Buying at a 6% cap based on $200,000 isn't the same deal as buying at a 6% cap based on the proforma $250,000.
Cap rate doesn't account for capital expenditure. A property with a 20-year-old roof and aging HVAC has effective NOI lower than the trailing 12-month statement suggests.
How cap rate relates to mortgage rates
Cap rates roughly track interest rates over long periods because investors demand a spread over financing costs. When mortgage rates rise, cap rates eventually rise too (often with a lag), pulling values down. That's why commercial real estate values fell 15–25% in 2022–2024 in many sectors.
Run the numbers on your loan
See your real monthly PITI payment with PMI, taxes, insurance, and a full amortization schedule.
Open the calculator →