Cap rate.
What it actually means.

What it is

Cap rate is the yield a property produces if you paid cash for it. By deliberately excluding the mortgage, it separates the quality of the asset from the quality of your financing, which is what makes two deals comparable when one buyer is borrowing at 7% and another is paying cash. It is simultaneously a return measure and a pricing convention: in commercial and small multifamily markets, buyers and sellers negotiate in cap rates the way stock investors talk in multiples, because the number carries an implicit view of risk and growth.

How it is calculated

Divide net operating income by the purchase price. NOI is annual rental income less all operating expenses — taxes, insurance, management, maintenance, vacancy, and reserves — but before debt service and income taxes. A property with $12,000 of NOI bought at $150,000 yields 8%. Flip the formula and it prices assets instead: at a 7% market cap rate, that same $12,000 of NOI implies a value near $171,000. This is why raising NOI by $1,000 can add roughly $14,000 of value in a 7% market, and why operators chase small permanent expense reductions.

Cap rate = NOI ÷ price × 100. Rearranged, value = NOI ÷ cap rate — so $12,000 of NOI at a 7% market cap rate implies a value near $171,000.

How investors actually use it

Three ways. As a comparison tool, to rank deals in different markets without financing noise. As a valuation tool, applying the prevailing local cap rate to a property’s NOI to test whether the asking price is defensible. And as a market read, since cap rates compress when capital is plentiful and expand when it is scarce — a market that traded at 5% and now trades at 7% has repriced, whether or not rents moved. Buy-and-hold investors pair it with cash-on-cash return, because cap rate says what the asset earns while cash-on-cash says what you earn.

The common mistake

Using a seller’s NOI. Marketing packages routinely omit management on the theory that you will self-manage, understate vacancy, carry the seller’s legacy insurance premium, and use the current tax bill rather than the reassessed one that follows a sale. Each omission inflates NOI, and because cap rate divides by price, an inflated NOI inflates the apparent yield directly. Rebuild NOI from your own figures before computing the ratio, and remember that tax and insurance treatment varies by state — consult a professional for the property you are actually buying.