What is cap rate and how do I calculate it for a rental?

Cap rate is one of the most used, and most misunderstood, metrics in rental property investing. Calculated correctly, it is a clean way to compare properties independent of how they are financed. Used carelessly, it leads investors to overpay or overlook hidden risk. Here is how it actually works.

The cap rate formula

Cap Rate equals Annual Net Operating Income divided by Purchase Price.

Net Operating Income is your gross rental income minus all operating expenses: vacancy, property management, maintenance, CapEx reserves, taxes, and insurance. It does not include mortgage payments. That is intentional. Cap rate is a property-level metric that measures the asset itself, independent of how you finance it.

A worked example

You are looking at a duplex listed at $280,000. Each unit rents for $1,200 per month, so gross rent is $2,400 per month or $28,800 per year. Deduct 8 percent vacancy ($2,304), 10 percent property management ($2,880), 10 percent maintenance and CapEx ($2,880), $3,600 per year in taxes, and $1,800 per year in insurance. Total operating expenses: $13,464.

NOI equals $28,800 minus $13,464, which is $15,336. Cap rate equals $15,336 divided by $280,000, which is 5.48 percent.

Notice that this calculation uses no mortgage information. Whether you buy the duplex with cash or borrow 80 percent, the cap rate is the same: 5.48 percent. That is what makes it useful for property-to-property comparison.

What is a good cap rate?

It depends entirely on the market. In coastal cities like San Francisco or Seattle, cap rates of 3 to 4 percent are common because prices are high relative to rents. Investors buying there are primarily betting on appreciation, not cash flow. In Midwest markets like Cleveland, Indianapolis, or Kansas City, 7 to 9 percent cap rates are achievable because rents are strong relative to purchase prices.

As a rough benchmark: below 4 percent is a low-yield market where appreciation does most of the work; 5 to 7 percent is moderate, typical of secondary and growing markets; above 8 percent often signals either strong cash flow potential or elevated risk, such as older properties, challenged neighborhoods, or markets with weaker long-term demand.

There is no universal target. A 5 percent cap rate in Austin is a very different investment than a 5 percent cap rate in Detroit. The number only means something relative to the local market and your investment thesis.

Higher cap rate does not always mean better deal

A 10 percent cap rate in a declining market with high tenant turnover may be a worse investment than a 5 percent cap rate in a stable, appreciating neighborhood. Cap rate captures only current income relative to current price. It says nothing about appreciation potential, local rent growth trajectory, or neighborhood direction.

Use cap rate to filter and compare. Then evaluate what is actually driving the number. A high cap rate can mean strong cash flow, but it can also mean the market has priced in risk that you should understand before buying.

Cap rate vs cash-on-cash return

These two metrics are often confused because they both measure return. The key difference: cap rate ignores financing, cash-on-cash return includes it.

If you buy the $280,000 duplex with 25 percent down and finance the rest at 7 percent, your mortgage payments change the return you actually see on your invested dollars. Cash-on-cash captures that. Two investors buying the same property, one with 20 percent down and one with 30 percent down, will have different cash-on-cash returns but identical cap rates.

Use cap rate to compare properties and benchmark against the market. Use cash-on-cash to evaluate whether your specific deal and financing terms make sense for you.

How Realastat calculates cap rate

Realastat calculates cap rate automatically for every deal. Upload a listing screenshot, select the market, and the full NOI breakdown, including income, vacancy, and each operating expense line, is calculated and displayed alongside cap rate, cash-on-cash return, DSCR, and break-even rent. You can edit any input and every metric recalculates instantly, so you can see exactly how a lower purchase price or higher rent estimate moves the cap rate.