Cap Rate Explained Without the Spreadsheet

You've got a rent roll open in one tab and a listing price in another, and you're trying to figure out if this property is actually a deal or just a number someone dressed up nicely. That's what cap rate is for. Here's the answer, then the details that matter.

Cap rate is net operating income divided by purchase price. That's it.

A property that nets $60,000 a year in income, on a $1,000,000 purchase price, has a 6% cap rate. Higher cap rate means more income relative to price. Lower cap rate means you're paying more for the same income, usually because the market thinks the property or the location is safer, or has more upside.

What Counts as Net Operating Income

This is where most people mess up the math before they even get to the division.

Net operating income, NOI, is rent collected minus operating expenses. It is not the same as cash flow, and it does not include your mortgage payment.

Take a fourplex renting for $1,200 per unit, per month. That's $4,800 a month, or $57,600 a year, if every unit is full every month.

Nobody's fourplex is full every month. Subtract a vacancy factor. Say 5%, which is $2,880. Now you're at $54,720 in effective gross income.

Then subtract operating expenses: property taxes, insurance, repairs, management, landscaping, any utilities you cover. Say that runs $16,000 a year for this building. Now your NOI is $38,720.

If the listing price is $500,000, the cap rate is $38,720 divided by $500,000, which is 7.74%.

Notice what's missing. No mortgage payment. No loan interest. No down payment. Cap rate is a measure of the property's performance on its own, as if you paid all cash. That's the whole point of it. It lets you compare a property in Dallas to a property in Tampa without the comparison getting distorted by whoever's individual loan terms.

Why Sellers and Agents Quote Cap Rate the Way They Do

Here's what people get wrong constantly, and it costs them real money.

A seller or listing agent will hand you a cap rate calculated on pro forma numbers, meaning projected rents, not actual rents. Or they'll use "market rent" instead of what the current tenants are actually paying. Or they'll leave out a real expense like a management fee, because the current owner self-manages and doesn't want to pay for it, but you will.

I've seen a listing advertise an 8% cap rate that dropped to 5.9% once I plugged in actual property management costs and a realistic vacancy number instead of the seller's rosy 2%.

Always ask for trailing twelve months of actual income and expenses, not projections. If a broker only has a pro forma, that alone tells you something.

The other common mistake is treating cap rate as the only number that matters. It's a snapshot, not a verdict. A 4% cap rate property in a growing area with rising rents can outperform an 8% cap rate property in a shrinking town over five years. Cap rate tells you what the property earns today, relative to price today. It says nothing about tomorrow.

Cap Rate vs Cash on Cash Return

People confuse these two, and it matters because they answer different questions.

Cap rate ignores financing. Cash on cash return is about your actual money, meaning your down payment and closing costs, versus your actual cash flow after the mortgage.

Go back to that $500,000 fourplex with $38,720 NOI. If you pay all cash, your cap rate and your cash on cash return are close to the same thing, around 7.7% before accounting for closing costs.

But say you put 25% down, $125,000, and finance the rest at 7% interest on a 30-year loan. Your annual debt service runs around $28,700. Subtract that from your NOI of $38,720 and your actual cash flow is $10,020 a year.

Divide that $10,020 by your $125,000 down payment and your cash on cash return is 8%.

In this case the return on your borrowed money is actually a bit higher than the cap rate, because the property earns more than the cost of the debt. That gap, the difference between what a property earns and what your loan costs, is the whole reason people borrow money to buy real estate. When the math runs the other way, when your debt service costs more than the property earns, the debt works against you instead of for you. That's the difference between the two numbers, and why you need both, not just one.

What a "Good" Cap Rate Actually Means

There's no universal good number. A 4% cap rate in a coastal city with strong appreciation and low crime can be a completely reasonable price. A 10% cap rate in a declining industrial town might be pricing in real risk, like a shrinking tenant pool or a factory that just closed.

Cap rate tracks with risk and growth expectations, roughly the same way bond yields do. Lower cap rate generally means the market believes the location is stable or improving. Higher cap rate generally means the market wants to get paid more for taking on more uncertainty.

What you should do is compare similar properties in the same submarket, using the same method for calculating NOI, and see where a specific listing lands relative to that local range. A cap rate only means something next to other cap rates from the same kind of building, in the same area, calculated the same way.

One Honest Limitation

Cap rate tells you nothing about your specific financing, your tax situation, or what the property will be worth when you sell it. Two investors can look at the exact same 6% cap rate deal and have completely different outcomes, because one financed it at 6.5% interest and the other at 8%, or because one held for ten years through a rezoning and the other sold in year two. Cap rate is a starting filter, not a full underwriting. Use it to screen properties quickly, then run the real numbers, your actual loan terms, your actual expenses, your actual exit assumptions, before you commit to anything.

If you're running these numbers on a live deal right now and want to see how the full picture holds together, that's exactly what Deal Machine is built for. It takes the rent roll, the expenses, and the financing you're actually looking at, and shows you the full return, not just the one ratio. You can find it at readmoneydecoded.com/deal-machine.

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