Cap rate is annual net operating income (NOI) divided by price—a quick read of income yield before financing. Higher can mean more income relative to cost, or more risk priced into the market. Compare it alongside cash flow and debt coverage, not in isolation.
$18,000 ÷ $300,000
6.0%
Uses purchase price only
$18,000 ÷ $330,000
5.5%
Price + closing + rehab in this sample
Same NOI, larger denominator → lower cap rate. Neither figure includes the mortgage—check cash flow and DSCR after financing.
Purchase vs pro forma
A purchase cap rate uses annual NOI over purchase price. A pro forma (or going-in) cap rate often uses all-in project cost—purchase plus closing, rehab, and points—so the denominator reflects what you really put into the asset before financing.
Neither figure includes your mortgage payment. That is why two deals with similar cap rates can have very different cash flow once leverage and rate enter the picture.
How to use it
Use cap rate to compare income properties in a market or to sanity-check whether a listing is priced richly or cheaply relative to its NOI. Then confirm the story with cash flow, cash-on-cash, and DSCR under financing you would actually use.
What's a good cap rate?
It varies from investor to investor and property to property. In general, the higher the cap rate, the greater the risk and the return.
In real life, cap rate tells you how much income the property throws off relative to what you pay—before the mortgage. A higher number usually means more yearly income for the price, and often more risk (weaker location, older building, less reliable tenants). A lower number usually means you’re paying more for each dollar of income, often for a steadier or more competitive property.
Example: two rentals each make about $18,000 a year in NOI. One costs $300,000 (6% cap). The other costs $360,000 (5% cap). The 6% deal gives you more income per dollar of purchase price; the 5% deal costs more up front for the same income. Whether 6% is “good” for you depends on your market, how much risk you’ll take, and whether cash flow still works after you add a loan.
Key considerations
Cap rate is a useful screen—not a full underwriting. Keep these points in mind:
- NOI quality matters — optimistic rent or understated expenses inflate NOI and the cap rate with it.
- Financing is invisible — the same cap rate can produce very different cash flow once down payment, rate, and term enter the model.
- Purchase vs all-in cost — comparing a purchase cap rate to a pro forma (price + closing + rehab) mixes apples and oranges unless you label which you are using.
- Market context — a “high” or “low” cap rate only means something relative to similar properties in that market and risk profile.
- One metric is not enough — pair cap rate with cash flow, cash-on-cash, and DSCR before you treat a deal as attractive.