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What is a cap rate?
Cap rate, short for capitalization rate, is a quick way to compare rental properties. It's the property's yearly net operating income divided by its price or value, shown as a percentage.
In a little more detail
Net operating income is the rent you collect minus the costs of running the property, like taxes, insurance, repairs and management. It doesn't include your mortgage payment.
Because it ignores financing, cap rate lets you compare two properties on equal footing, whether you'd buy them with cash or a loan. A higher cap rate usually means more income for the price, and often more risk.
- A building brings in $40,000 a year in rent and costs $16,000 a year to run.
- Net operating income: $40,000 − $16,000 = $24,000.
- It's priced at $400,000. Cap rate: $24,000 ÷ $400,000 = 6%.
Things to watch
- Use real expense numbers, not the seller's best guess.
- Cap rate leaves out the mortgage. Look at cash flow too.
- Compare it with similar properties in the same area.
The Cash Flow Calculator shows what a rental really earns each month after every cost, including the mortgage.
This is a plain-English explanation, not legal advice. Rules vary by state and city, so check your local law or talk to an attorney before you act on it.
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