What cap rate is

Capitalization rate – ‘cap rate’ – is a simple ratio that tells you how efficiently a rental property generates income relative to its price. The formula:

Cap rate = Net Operating Income (annual) ÷ Purchase Price

Net Operating Income (NOI) is the rent you collect minus all operating expenses – property taxes, insurance, repairs, management, vacancy reserve – before the mortgage payment. The mortgage is a financing decision, not an operating one, so it’s excluded.

A worked example

You’re looking at a single-family rental at $280,000.

• Expected annual rent: $27,600 ($2,300/month)
• Vacancy reserve at 5%: $1,380
• Effective gross income: $26,220
• Property taxes: $3,200
• Insurance: $1,400
• Maintenance + repairs reserve: $2,760
• Property management at 10%: $2,622
• NOI: $16,238

Cap rate = $16,238 ÷ $280,000 = 5.8%

What the number means

A 5.8% cap rate means the property, unlevered, returns 5.8% a year. Is that good? It depends entirely on your market and your goals.

• In high-appreciation markets (coastal metros), 4 – 5% is normal. Investors accept lower current yield because they’re betting on appreciation.
• In stable, slower-growth markets, 6 – 8% is common.
• Above 9%, you’re usually in lower-quality neighborhoods, older housing stock, or distressed situations where the higher return is compensating for higher risk.

Where cap rate stops being useful

It ignores financing. Two investors buying the same property can have wildly different returns depending on whether they pay cash or put 25% down. For that, you need cash-on-cash return, which is a different calculation.

It doesn’t reflect appreciation. Cap rate is a current-income ratio. If the property’s land value is climbing 5% a year, that’s invisible in the cap rate.

It depends on honest expense assumptions. Most sellers present optimistic numbers. Budget for what the property actually costs to run, not what the listing says.

A simple screening habit

When you’re screening properties, calculate cap rate using conservative expense assumptions. Compare across properties in your target market. Anything that looks dramatically higher than the neighborhood average usually has a reason – find it before you bid.

If you’d like Lux to run a conservative cap-rate analysis on a property you’re considering, we do that as part of our pre-acquisition support for investor clients. No cost, no obligation.