Cap Rates Explained: The 60-Second Math Behind Every Property Investment
What a cap rate actually tells you, how to calculate it from NOI, why low cap rates aren't bad, and the mistakes beginners make comparing deals.
Cap rate is the first number investors quote and the first one beginners misuse. The math takes a minute; the judgment takes longer — here's both.
The formula
Cap rate = net operating income (NOI) ÷ purchase price. NOI is all rental income minus all operating expenses — taxes, insurance, maintenance, management, vacancy — but not the mortgage. A property earning $60,000 NOI priced at $1,000,000 has a 6% cap.
What it actually measures
The unleveraged return: what the property yields if you paid cash. That makes it a clean tool for comparing properties to each other — and to alternatives like bonds — without financing muddying the picture.
Why a low cap rate isn't 'bad'
Cap rates price risk and growth. A 4% cap in a prime location says the market expects stable income and appreciation; a 9% cap in a struggling area says the income is riskier. Chasing the highest cap rate is just chasing the most risk — the question is whether the rate fairly compensates for it.
The beginner mistakes
- Trusting the seller's 'pro forma' NOI — underwrite from actual rents and real expenses, not projections.
- Forgetting vacancy and management in NOI, which inflates the cap by a point or more.
- Comparing cap rates across different property types or cities as if they were interchangeable.
Cap rate compares deals. Cash-on-cash return tells you what your actual money earns. You need both.
Frequently asked
What's a 'good' cap rate?
There's no universal number — prime multifamily might trade at 4–5% while older retail trades at 8%+. 'Good' means at or above the market cap rate for that asset type and location, with honest NOI behind it. Theo can help you benchmark a specific deal.
Do cap rates apply to single-family rentals?
The math works anywhere, but small residential investors more often use cash flow and cash-on-cash return since financing dominates the picture. Cap rate still helps when comparing purchase prices.
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