Cap Rate Explained: What a Cap Rate Tells You (and Doesn't)
A cap rate (capitalization rate) is a property’s net operating income divided by its price or value. A fourplex with $83,338 of NOI that sells for $1,500,000 trades at about a 5.6% cap rate. It’s the property’s yield before financing, so it lets you compare buildings on the same footing, and there’s no single “good” cap rate: the right one depends on the property type, location, condition, lease terms and the cost of money when you buy.
The formula is one line. The work is in the NOI underneath it. In California, a marketed cap rate is sometimes built on the seller’s old property tax bill and a rent roll that hasn’t been checked, so the same building can show a 7.3% cap rate in the brochure and a 5.6% cap rate on the buyer’s numbers. This guide shows how to read a cap rate, how to rebuild one, and what it can’t tell you. Our guide to calculating net operating income covers the NOI lines in detail; we don’t repeat them here.
The cap rate formula, three ways
The same relationship answers three different questions. Rearrange it depending on what you know.
| What you want | Formula | Example |
|---|---|---|
| The cap rate | NOI ÷ price | $83,338 ÷ $1,500,000 = 5.6% |
| A value from a market cap rate | NOI ÷ cap rate | $83,338 ÷ 5.0% = $1,666,760 |
| The NOI a price requires | Price × cap rate | $1,500,000 × 6.0% = $90,000 |
Small changes in the rate move value a lot. The same $83,338 of NOI is worth about $1,666,760 at a 5% cap rate and about $1,388,967 at 6%, a difference of almost $278,000. That’s why a buyer and seller can agree on the NOI and still be far apart on price.
These figures are an illustration, not market data. They come from the hypothetical North Bay fourplex in our NOI guide.
What a cap rate tells you, and what it doesn’t
A cap rate is a snapshot of one year’s income against today’s price. It’s useful for comparing similar properties and for reading how the market prices a type of building.
- It ignores financing. Two buyers of the same building have the same cap rate and very different cash flow. Our cash-on-cash return guide carries the analysis below the debt line.
- It ignores capital spending. A building that needs a roof, a sewer lateral or seismic work can look cheap on a cap rate and be expensive to own.
- It ignores growth. A cap rate doesn’t show rent upside, rent limits or appreciation. Two buildings at the same cap rate can have very different futures.
- It isn’t a total return. Measures such as internal rate of return add the timing of cash flows, the sale price and financing. A cap rate is the starting point, not the answer.
Rebuilding a marketed cap rate
A listing’s cap rate is only as good as the NOI behind it. Before you compare it with anything, rebuild it on your own numbers. Our full rental property analysis walks through the underwriting; these are the lines that most often change the cap rate.
Property tax after the sale
When a California property changes ownership, the Board of Equalization explains, the assessor reassesses it to its current fair market value as of the date ownership changed. A long-time owner’s tax bill can be a fraction of yours, so replace it with your price times the full tax rate, plus fixed charges. Expect a supplemental tax bill as well, and see our guide to California property tax for investors.
Actual versus pro forma income
Ask whether the NOI is actual (the trailing 12 months) or pro forma (projected). A pro forma cap rate that assumes rents jump to market isn’t comparable with a cap rate on actual income, especially on units covered by the state rent cap; see AB 1482 for landlords.
Missing expenses
Management, a vacancy allowance and replacement reserves are the usual omissions, particularly when the seller manages the building personally.
Worked example: the same building, two cap rates
| Line | Seller’s marketing | Buyer’s rebuild |
|---|---|---|
| Price | $1,500,000 | $1,500,000 |
| Vacancy and credit loss | None | 3% of gross potential rent |
| Property tax | $4,000 (seller’s current bill) | $16,500 (1.1% of the price) |
| Management | None (self-managed) | 6% of effective gross income |
| Reserves | None | $400 per unit |
| NOI | $109,400 | $83,338 |
| Cap rate | 7.3% | 5.6% |
Nothing about the building changed. The 1.7-point gap comes entirely from how the expenses were stated. The figures are hypothetical and match the example in our NOI guide; your tax rate, rents and costs will differ.
Going-in, stabilized and exit cap rates
- Going-in cap rate: first-year NOI, on your underwriting, divided by your purchase price. This is the number to compare with closed sales.
- Stabilized cap rate: NOI after a vacant or under-rented building reaches normal occupancy and rents, divided by the price. It depends on assumptions you’ll have to deliver.
- Exit (terminal) cap rate: the rate you assume a future buyer will pay when you sell. Be wary of a model that assumes a lower exit rate than the going-in rate: it inflates the projected sale price, and a conservative model assumes the same rate or a higher one.
When you compare a listing with comparable sales, make sure every cap rate in the set was calculated the same way: actual or pro forma, with or without reserves, and on the buyer’s tax or the seller’s.
Cap rates, interest rates and leverage
Cap rates respond to the cost of money, but not one for one. CBRE’s U.S. Cap Rate Survey for the first half of 2026, published August 12, 2026, found the all-property average cap rate essentially flat even though the 10-year Treasury yield had risen, peaking at 4.67% in mid-May. About 60% of responses expected no change in cap rates, and more respondents expected increases than in CBRE’s December 2025 survey. CBRE also reported more compression for class B and C and value-add assets than for class A and stabilized assets.
Financing can work against you. Freddie Mac’s survey put the average 30-year fixed mortgage rate at 7.32% for the week of October 22, 2026; that’s a benchmark for owner-occupied loans, and investor and commercial loans are priced differently. At that rate, a 30-year loan’s annual payments equal about 8.24% of the balance. If the building in our example yields 5.6% and you borrow 60% of the price, $900,000, the payments come to about $74,189 a year. That leaves about $9,149 of cash flow on $600,000 of equity, roughly 1.5%, and a debt service coverage ratio of about 1.12. When the cap rate is below the loan’s cost, borrowing lowers your cash return. Our guide to apartment building loans explains how lenders size loans from NOI.
Why a low cap rate isn’t automatically a bad deal
A buyer who accepts a low cap rate is usually paying for something the first year’s NOI doesn’t show: below-market rents that can rise when units turn over, a location where supply is hard to add, the chance to add units, or a long-term hold where appreciation matters more than current yield.
The risk is that those expectations don’t arrive. Rent caps, vacancy, insurance costs and capital needs can all hold NOI down. Price the property on what you can verify, then treat the upside as something you’re paying for, not something you’re owed. Diamond doesn’t publish a cap rate average for our markets; we pull the closed comparable sales for the property type and street when we advise a client.
How appraisers and assessors use cap rates
The income approach to value divides NOI by a cap rate, as appraisers do for apartment buildings and commercial property; see our guide to commercial property valuation for how it fits with the sales comparison and cost approaches.
California’s assessors follow Property Tax Rule 8. It allows two ways to develop a cap rate: comparing the net incomes of recently sold comparable properties with their prices (the market-derived rate, which the rule prefers when the data exist), or a weighted average of the rates for debt and equity capital (the band-of-investment method). The assessor’s rate includes a property tax component, equal to the area’s estimated future tax rate times the assessment ratio, so the assessor’s NOI leaves property tax out. Don’t compare your cap rate with an assessor’s without adjusting for that.
Commercial and net-leased property
For a single-tenant building, the cap rate largely prices the lease: the tenant’s credit, the years remaining, rent increases and who pays for the roof and structure. A long lease to a strong tenant often trades at a lower cap rate than the same building with a short lease, because the income is more certain. Our guide to buying NNN-leased property covers lease review, and our commercial real estate page covers sales and leasing.
Questions people ask
What is a good cap rate?
There’s no single good number. Compare a property’s cap rate, rebuilt on your own NOI, with closed sales of similar buildings in the same area, then weigh what the price buys you in condition, rent upside and risk.
Is a higher cap rate better?
A higher cap rate means more income per dollar of price, but it often comes with more risk: an older building, a weaker location, a shorter lease or less room for rent growth. It’s better only if the extra yield pays you for that risk.
How do I calculate the cap rate on a rental property?
Calculate NOI (income after vacancy and operating expenses, before mortgage payments), then divide it by the price. Use your reassessed property tax and include management and reserves.
Does a cap rate include the mortgage?
No. A cap rate is calculated before debt service. To see the effect of financing, use cash-on-cash return or the debt service coverage ratio.
What’s the difference between cap rate and cash-on-cash return?
The cap rate compares NOI with the full price. Cash-on-cash return compares the cash left after debt service with the cash you actually invested, so it changes with the loan.
Can I use cap rates for single-family rentals?
You can calculate one, but single-family homes usually sell on comparable sales to owner-occupants, not on income. A cap rate tells you how a house works as a rental, not what it will sell for.
Why do the cap rates on listings look higher than the ones I calculate?
Usually because the listing uses the seller’s property tax, leaves out management or reserves, or uses pro forma rents. Rebuild the NOI before you compare.
If you’re weighing an income property, or want to know what yours would trade for, we can rebuild the NOI and pull comparable sales with you. Start with our investment property services, or see how we help owners sell multifamily buildings.
This is general information, not legal, tax or investment advice; talk to a California CPA or tax adviser about your situation.
Sources & notes
- CBRE: U.S. Cap Rate Survey H1 2026 (August 12, 2026)
- Freddie Mac: Primary Mortgage Market Survey (week of October 22, 2026)
- California State Board of Equalization: Change in ownership FAQs
- Cornell LII: California Code of Regulations, title 18, section 8 (Property Tax Rule 8)
The worked examples use hypothetical figures to show the method; they are not market data. The loan payment figure is arithmetic on Freddie Mac’s published average rate. CBRE’s survey reports sector cap rates in its full report; this page cites only the findings stated in its summary.
Last reviewed October 2026 by Matthew Martinez.
