The direct answer
Cap rate is annual net operating income divided by property price or value, expressed as a percentage. It measures a property-level income relationship before debt service. It does not describe the investor’s cash contribution, principal repayment or eventual sale proceeds.
Choose a consistent income period
Use annual NOI covering the same period and assumptions as the value basis. Trailing income, an initial lease-up year and stabilized income are different scenarios. Label which one you are using. A forward-looking number can be useful, but calling it current income would conceal the assumptions needed to achieve it. Gross scheduled rent is not an interchangeable numerator because vacancy and operating costs have not yet been deducted.
To apply the approach to an editable scenario, use the Cap Rate Calculator. For the neighboring question, explore NOI Calculator.
Price and value answer different questions
Dividing by the proposed purchase price shows the income relationship at that price. Dividing by an independently estimated property value uses another denominator. For a fixed NOI, a lower denominator produces a higher cap rate. This sensitivity can help evaluate how a price change affects the relationship, but it cannot establish the correct price without credible income and comparable market evidence.
Understand what the percentage leaves out
The measure excludes financing and does not tell you how much cash remains after the loan payment. Properties with similar rates may have different lease rollover, repair exposure or income reliability. Comparisons need a consistent reserve and operating-expense convention. A high modeled percentage should prompt questions about the assumptions and risks, rather than an automatic buy conclusion.
Worked example
For the calculator’s example, $30,000 of annual NOI divided by $500,000 of property value gives 0.06, or 6%. At $600,000 with the same NOI, the rate is 5%. The $100,000 denominator change affects the metric even though the property’s modeled operations are unchanged.
Common mistakes and limitations
Subtracting debt service before calculating cap rate creates an after-financing ratio. Using gross rent overstates the numerator. A zero price makes the ratio unavailable; it does not imply a zero income yield.
Cap rate depends on the quality and stabilization of the NOI assumption and does not by itself measure leveraged investor return.
Frequently asked questions
Is cap rate the annual total return?
No. It excludes appreciation, sale proceeds and financing effects. It is an income-to-property-value relationship.
Should I use a market cap rate as a guarantee?
No. A selected market assumption depends on income definitions and the relevance of the comparison evidence.
Sources and further reading
The article’s examples are illustrative arithmetic. The references below provide context for operating, valuation or transaction concepts; they do not endorse the assumptions or the calculator.
- Office of the Comptroller of the Currency — Comptroller's Handbook — Commercial Real Estate LendingNOI, direct capitalization, cap-rate valuation and DCF concepts for commercial real estate.
- Appraisal Institute — Basic Formulas — Income CapitalizationIncome/cap-rate/value relationships, gross income multiplier and debt-coverage formula references.
Read our editorial policy for the scope of these educational methods.