Cap Rate Explained: What Every Real Estate Investor Needs to Know

A cap rate, short for capitalization rate, is a property's annual net operating income (NOI) divided by its price or current value. A six-unit building with $54,000 of NOI that sells for $900,000 has a 6.0% cap rate. NOI is counted before any mortgage payment, so the cap rate is roughly the yearly return an all-cash buyer would earn on the price; that makes it a standard tool for pricing apartment and commercial buildings, but a weak guide to what a single-family house is worth.

How to calculate cap rate

Cap rate = NOI / purchase price (or current value).

1. Add up a full year of rent for every unit at current lease rates, as if all were occupied, plus other income the property already collects, such as laundry or parking fees.
2. Subtract an allowance for vacancy and unpaid rent.
3. Subtract a year of operating expenses, including a reserve for replacing major parts.
4. Divide the result, the NOI, by the price.

Example: a six-unit building with each apartment renting for $1,500 a month.

$54,000 divided by $900,000 is a 6.0% cap rate.

Build NOI from the property's records, not the listing: current leases, an insurance quote, and the property tax you will owe after you buy. That tax can be higher than the seller's bill; in California, for example, the county assessor reassesses a property to its current market value when it changes ownership. If the listing shows a projected ("pro forma") NOI based on rents the building does not yet collect, recalculate it at today's rents. Include a management fee even if you plan to manage the building yourself, so its cap rate compares fairly with buildings that pay a manager.

What NOI includes and leaves out

The Office of the Comptroller of the Currency (OCC), which supervises national banks, defines NOI in its commercial real estate lending handbook as annual gross income minus operating expenses:

• Income includes rents and other income from operating the property, such as parking, laundry, and vending, plus tenant reimbursements, such as utility charges tenants repay, when the reimbursed expenses are also counted as operating expenses.
• Expenses include the costs of operating and normally maintaining the property, plus a replacement reserve for capital items such as a roof or boiler. The OCC counts the reserve whether or not the owner actually funds it.
• Left out are mortgage interest and principal, income taxes, depreciation, and the capital items themselves, since the reserve stands in for them.

Because the loan is left out, two buyers with different financing will calculate the same cap rate for the same building. It also means a property with a healthy cap rate can lose money for a buyer who borrows at a high rate. At 7.75%, the annual payments on a 30-year loan equal 8.6% of the amount borrowed, more than the 6.0% this building earns before financing, so borrowing lowers the buyer's cash return instead of raising it. Cash-on-cash return measures the result after the loan.

Using cap rates to value a property

Rearranged, the formula estimates value: value = NOI / market cap rate. Appraisers and lenders call this direct capitalization. The OCC handbook says it fits a property with stabilized NOI, meaning the building is leased up and its income is expected to stay steady. For a half-empty building or one about to be renovated, the handbook points to a discounted cash flow analysis instead, which projects the income year by year through the lease-up.

A rise in the market cap rate from 6.0% to 6.5% cuts the building's value by $69,231, or 7.7%, with no change in the building. The OCC notes that rising interest rates can push cap rates up and property values down even when a property's income has not changed. The same math works in your favor when NOI rises: at a 6.0% cap rate, each added dollar of NOI is worth about $16.67 of value, so raising NOI by $2,700 a year, $37.50 per unit per month, adds about $45,000.

Freddie Mac's appraisal guidance, quoting the Appraisal Institute, requires each comparable sale's NOI to be calculated the same way as the NOI of the building being valued, including how replacement reserves are treated. Before you use a broker's or published cap rate, ask whether it was figured before or after reserves: applying a before-reserve rate of 6.0% to this building's after-reserve NOI would understate its value by $50,000.

What published cap rates look like in 2026

Published cap rates come from sales of apartment and commercial buildings. Freddie Mac reported that multifamily cap rates rose 0.22 percentage point in the second quarter of 2026, to 5.8%, about 1.35 points above the 10-year Treasury yield. The Federal Reserve's May 2026 Financial Stability Report said cap rates on commercial property purchases had risen from the historic lows of 2022 to a level just below their historical average. The 10-year Treasury yield was 4.96% on October 22, 2026, so a building bought at a 5.8% cap rate would earn less than a point more than a Treasury note before any loan.

Use market figures to test a price, not to set one:

• Compare cap rates only among similar buildings, in the same market, sold at about the same time. How to analyze a rental property market covers finding local rents and sales.
• If a listing's cap rate is far above recent local sales, find out why before treating it as a bargain. Check the building's age and condition, its occupancy, and whether the seller's expense figures are complete.

Why cap rate can mislead on single-family homes

Cap rate works best for buildings that are bought and sold for their income. A house differs in three ways.

Its value comes from comparable sales. Fannie Mae's appraisal rules call for at least three closed comparable sales and treat sales in the same neighborhood as the best indicator of value. They require an income approach only for two- to four-unit properties, say it may not be appropriate where most homes are owner-occupied, and do not accept an appraisal that relies on income alone. When an appraiser does use income, the report shows a gross rent multiplier, the sale price divided by rent, drawn from comparable rentals and sales. A house's cap rate therefore shows how its rent compares with its price, not whether the price is right.

Vacancy is all or nothing. A house with its only tenant gone earns nothing, while a six-unit building with one empty apartment still collects five-sixths of its rent.

One repair can take most of a year's income. A $350,000 house renting for $2,000 a month might produce NOI of $12,555 after 6% vacancy, $4,200 of property tax, $1,700 of insurance, an 8% management fee, and $2,300 of repairs and reserves. That is a 3.6% cap rate, below the 10-year Treasury yield. A $9,000 replacement of the heating and cooling system equals 72% of that NOI, so if the system fails before the reserve has built up, most of the bill comes out of that year's income.

At that cap rate, a buyer who borrows 75% of the price at 7.75% would owe about $22,600 a year in principal and interest against $12,555 of NOI, a gap of about $10,000 a year paid from other funds. Rental property ROI shows how to weigh that against principal paydown and appreciation, single-family vs multi-family rentals compares the two property types, and how to buy your first rental property covers the rest of the purchase.