When I first got into real estate, I assumed the hardest part would be finding the right property. Turns out, that was the easy part. The real challenge? Knowing whether the deal actually made financial sense.
A few years ago, a friend excitedly called me about a “can’t-miss” rental property. Nice neighborhood, solid rent, even a fresh coat of paint. But when I asked about the cap rate, the line went silent.
That’s when I realized how many new landlords jump in without understanding this key metric. Some get lucky. Others end up owning a headache disguised as an investment.
If you’re thinking about buying your first rental—or just want to sharpen your analysis—this guide is for you. I’ll walk you through what cap rate is, why it matters, how to calculate it, and how to use it to make smarter decisions. No jargon, no fluff—just real numbers and practical advice.
Understanding Cap Rate: A Beginner’s Guide for Landlords
How to Calculate Cap Rate (It’s Easier Than You Think!)
What Cap Rate Tells You About Your Investment
How to Use Cap Rate When Buying Property
Why Cap Rate Isn’t the Only Number That Matters
What Are The Other Factors That Matter?
Cap Rate vs. Cash-on-Cash Return
Cap Rate vs IRR (Internal Rate of Return)
Which Number Should You Watch?
What Is Cap Rate?
Cap rate (short for capitalization rate) is the percentage of your property’s value you can expect to earn each year. Think of it like this: if you buy a house with cash, cap rate tells you how much money comes back to you yearly after paying all the bills (except the mortgage).
Here’s a real-world example:
- You buy a rental property for $200,000
- After collecting rent and paying expenses like taxes, insurance, and repairs, you keep $12,000 per year
- Your cap rate is 6% ($12,000 ÷ $200,000 = 0.06 or 6%)
That 6% is like the “yield” on your investment. Higher cap rates mean better income compared to what you paid.
How to Calculate Cap Rate (It’s Easier Than You Think!)
You don’t need to be a math wizard to figure out cap rate. Just follow these steps:
- Add up your yearly rental income
Example: $1,500 monthly rent × 12 months = $18,000 per year - Subtract your yearly expenses
Things like property taxes, insurance, repairs, and management fees
Example: $6,000 in yearly expenses - Find your Net Operating Income (NOI)
This is your rental income minus your expenses
Example: $18,000 – $6,000 = $12,000 NOI - Divide your NOI by your property value
Example: $12,000 ÷ $200,000 = 0.06 or 6%
That’s it! Your cap rate in this example is 6%.
What Cap Rate Tells You About Your Investment
Cap rate is more than just a number. It gives you important clues about your potential investment:
1. How Long Until You Get Your Money Back
A simple way to think about cap rate is how many years it would take to get your money back (if nothing changes):
- 5% cap rate = about 20 years to recoup your investment
- 10% cap rate = about 10 years to recoup your investment
2. Risk Level
Cap rates usually tell you something about risk:
- Low cap rates (3-5%) often mean safer investments in good neighborhoods with reliable tenants. However, these properties may also have low cash flow and would need higher down payment (sometimes greater than 40%) to meet lender’s requirements.
- High cap rates (8-10% or higher) often mean riskier investments, maybe in up-and-coming areas or buildings needing work. But “The sweeter the apple, the higher the branch.”
3. Property Value
Cap rate helps you figure out if a property is fairly priced. If similar rentals in your area sell at a 6% cap rate, a property with a $30,000 NOI should cost around $500,000 ($30,000 ÷ 0.06).
If someone’s asking $600,000 for that same property, the cap rate drops to 5% ($30,000 ÷ $600,000). That might be too expensive compared to other options in your market.
How to Use Cap Rate When Buying Property
Follow these steps to use cap rate in your decision-making:
- Find out the typical cap rates in your target area.
Ask local real estate agents or look at similar property listings. - Calculate the cap rate for any property you’re considering.
Be honest about income and expenses – don’t fudge the numbers! - Compare to the local average.
If your property’s cap rate is much higher than average, ask why. Is it a great deal, or is there a hidden problem? - Factor in your plans for the property.
If you know you can raise rents or cut expenses, your future cap rate might be better than the current one.
Remember, buying property isn’t just about numbers – it’s about finding a good fit for your goals and abilities. A fixer-upper might have a great potential cap rate, but only if you have the skills or connections to improve it.
Why Cap Rate Isn’t the Only Number That Matters
Cap rate is super helpful, but it does have limits:
- It ignores your mortgage. If you’re borrowing money to buy property (like most investors), cap rate doesn’t show your actual return on the cash you put down.
- It’s a snapshot in time. It doesn’t account for rising rents or future property value growth.
- It varies by location. A “good” cap rate in New York City might be 4%, while in a small town, investors might expect 8% or more.
“Cap rate is like checking the temperature outside. It tells you something important, but you still need to look at the whole weather forecast before deciding what to wear.” – real estate mentor
What Are The Other Methods to Evaluate a property?
There are two other metrics that are most commonly used evaluation a real estate investment: cash-on-cash Return and Internal Rate of Return (IRR).
Cash-on-Cash Return
When you’re using a mortgage to buy property, you should also look at “cash-on-cash return.” This shows what you’re actually earning on the money you invested.
For example:
- You buy a $200,000 property with a $40,000 down payment (20%)
- Your NOI is $12,000, but your yearly mortgage payments are $9,000
- Your actual cash flow is $3,000 ($12,000 – $9,000)
- Your cash-on-cash return is 7.5% ($3,000 ÷ $40,000)
In this case, your cap rate (6%) is lower than your cash-on-cash return (7.5%) because you’re using “leverage” (borrowing money). This is why many investors love real estate – your actual returns can be higher than the cap rate suggests.
IRR (Internal Rate of Return)
Remember how cap rate shows what your property earns this year as a percentage of its total value? IRR takes that idea much further.
Here’s how they differ:
- Cap rate only looks at one year (usually the current one)
- IRR looks at all the years you own the property
- Cap rate ignores your mortgage and how you paid for the property
- IRR includes everything: purchase, mortgage, yearly income, AND sale
Let’s assume you found a duplex for $300,000:
- The property had a decent 6% cap rate
- You put down $60,000
- Each year, you pockets $4,200 after all expenses
- Your cash-on-cash return: 7% ($4,200 ÷ $60,000)
Not bad! But here’s where it gets interesting.
Five years later, you sold the duplex for $375,000. When you calculate the IRR including all rental income plus the sale profit, it came to 13.5%!
The cap rate (6%) was okay. The cash-on-cash (7%) was good for monthly income. The IRR (13.5%) showed it was an excellent long-term investment.
That’s why looking at all three numbers gives you the complete picture!
As my real estate mentor used to say, “Cap rate tells you if you can afford the property today. IRR tells you if you’ll be happy you bought it tomorrow.”
Property Tracking Made Simple
Usually, Spreadsheets are used to organize such information to finalize the cap rate, and the return on any investment. But nowadays, various tools such as FourCasa help you track cap rate at the property, portfolio, LLC, and custom group level.These platforms have detailed and insightful reporting that provides you with a complete financial picture of your real estate portfolio. Furthermore, these platforms automate the mundane and works 24/7, detecting errors, anomalies, and offering actionable recommendations to keep your finances on track.
