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Summary
While real estate investing is often perceived as a lucrative venture, it also requires a deep understanding of various metrics to realize an investment’s profitability. One of the more popular metrics investors use is the capitalization rate, or “cap rate,” which assess a property’s return potential and level of risk. In this article, we’ll review what a cap rate is and how it’s calculated, what makes a cap rate good or bad, and how to use cap rate to inform your next property investment.
Cap rate plays a critical role in assessing real estate investments. Calculating it offers a way to compare properties and forecast future profitability as well as rate risk. Whether evaluating personal investments or doing so for a landlord, you’ll want to know what defines one as “best.” There’s no definitive answer to this, as so many factors impact its interpretation.
To ensure you’re using this metric optimally, you’ll find everything you need to know about cap rates in this article.
Cap rate basics
What is cap rate, exactly?
Cap rate measures a property's profitability and the rate of return an investor can expect to earn on their investment. The cap rate formula is:
Cap Rate = Net Operating Income (NOI) / Property Value
In other words, it’s a ratio between the property's net income and its value expressed as a percentage. For example, if a property has a net income of $100,000 per year and a value of $1 million, its cap rate would be 10%.
You can use the RentSpree cap rate calculator here.
It’s an essential metric in real estate investing because it provides a snapshot of a property’s profitability, regardless of its size or location.
While it doesn’t consider the value of money over time or future cash flows from the property, the calculation is a helpful tool that investors can use to compare the value of similar properties in one market quickly.
Some other benefits of using it include:
- Using it as a risk gauge: Safer investments typically have a lower cap rate, while riskier ones have higher rates. Lower and higher also describe the potential return for the property. The calculation can give them insight into how it would align with their appetite for risk.
- Market analysis: Cap rate can be part of analyzing your market in general, offering intelligence regarding market trends and dynamics across property types and geography.
What influences a "good" cap rate? (It's not just a number)
Several factors affect a property’s cap rate. While the formula gives you a ratio, it often needs context based on these things.
Location, location, location: Impact of market desirability on cap rates
Location is often the most influential factor in defining a “good” cap rate. Those properties on the market in desirable areas with high demand tend to have lower ones. In most cases, these buys would be a safe bet as a great rental.
Conversely, those in areas where desire and demand are much lower may have higher ones. There may be some uncertainty about whether you’d be able to attract renters and keep them occupied. One consideration, however, is analyzing if an area is emerging, meaning there’s been more activity, new development, or lots of updates to a neighborhood.
Property class (A, B, C): How property quality affects cap rate expectations
The classification of a listing can also impact the cap rate. Class A generally includes newer and well-maintained properties in sought-after areas. They usually have lots of renters interested and have much lower vacancy rates.
Class B includes older properties in less prime neighborhoods. These may still attract tenants, and there is also the opportunity to do some upgrades, which could improve this. It would increase the NOI, though.
Class C represents properties with the most age located in less desirable areas. As a result, it may require more maintenance and marketing to attract renters. It could be an emerging market, and you’d have the chance to get in early, but it’s a much higher risk.
Property type: Different risk profiles and cap rates
Another thing to consider is property type. You’ll also need context around outside factors regarding the market in demand. For instance, residential properties tend to be on the lower end, but where they are and their condition make a difference.
Commercial real estate can also vary. Office and retail spaces are sensitive to economic changes. How people work and buy affects this, too, as many companies in your area may have mostly remote employees and digital customers. Industrial properties may have lower cap rates if your manufacturing or logistics market grows.
Market conditions: Impact of interest rates, economic growth, and rental demand
The local and national market conditions also influence this metric. In a healthy economy with low interest rates, cap rates historically decrease as property values rise. When there are downturns or recessions and higher interest rates, they tend to spike.
Higher interest rates may also mean higher mortgage payments, which will reduce your NOI. Interest rates fluctuate, sometimes with volatility. Consider how changes may erode future profits when evaluating whether one is favorable.
Rental demand must also be part of the equation. It will be a primary factor in whether the property will attract and retain tenants. Any vacancy periods translate to no income.
"Good" cap rate ranges by property type (2025 edition)
Industry standards for cap rate vary depending on the property type and location, as well as an investor’s personal level of risk. We reviewed all the important things to know when assessing if one is “good.”
Here are some ranges by property type:
Multifamily: 4%-7%
This range represents primary markets with good demand, translating to steady income and less risk.
Single-family rentals: 5%-8%
These numbers correspond to many areas. Again, condition, location, and market conditions will provide context.
Commercial properties: 4%-10%
The type of commercial real estate has much to do with what’s considered a sound investment. How “good” it is to an investor depends on their goals, interest rates, and risk tolerance.
Real-world examples
The Cap Rate Index offers current rates by city across property taxes. Here’s a sample of average ones:
- Austin, TX: 5.59%
- Boston, MA: 5.83%
- Charlotte, NC: 6.46%
- Las Vegas, NV: 6.66%
- San Diego, CA: 4.52%
Why a higher cap rate isn't always better
A high cap rate may be what investors seek because they are less worried about risk and confident in future returns. It may be exactly what someone who plans to flip the property rather than keep it as rental property wants.
Higher cap rates mean a greater chance of more maintenance costs, renovation needs, and longer vacancy periods. The quality of tenants may be riskier as well because those who are the most desired aren’t interested in the location or only want newer properties.
Rising interest rates can also increase cap rates. Even though the calculation doesn’t consider financing, higher mortgages reduce income margins. If it’s an adjustable loan, it’s cause for concern. If interest rates can potentially disrupt returns, explore them before recommending them to clients.
Improving your cap rate
While you can’t change the location of your property, there are several things real estate investors can do to improve a property's cap rate.Here are some avenues to do this.
Increasing rental income: Strategies for raising rents
Refreshing the property can increase its value and rental income. Upgrading amenities, appliances, and finishes can attract higher-quality tenants willing to pay higher rents, resulting in a better cap rate.
Other tactics to increase income include:
- Adjusting rental rates based on market research.
- Sourcing high-quality candidates with a positive credit history.
- Robust tenant management (e.g., tenant screening, timely rent collection, and good communication with renters).
Reducing operating expenses: Cost-saving measures
Another angle for improvement is saving money. The best ways to do this include the following:
- Minimizing repair expenses by ensuring regular maintenance.
- Negotiating lower prices for new appliances and utility services.
- Installing energy-efficient appliances, lights, and windows.
Beyond cap rate: Additional metrics to consider
Remember, there are limitations to this ratio. It should be part of the decision-making process but not the only factor. There are other metrics to review, including:
- Cash flow: This is the actual money coming in minus expenses once the property is under lease.
- Cash-on-cash return: This measures income earned on the cash invested in a property.
- Internal rate of return (IRR): It’s another equation to calculate potential returns.
- Return on investment (ROI): ROI is how much someone would make on a property annually, factoring in mortgage payments.
Cap rate vs. cash-on-cash return: Which metric should investors prioritize?
The cap rate formula reveals the potential income without looking at debt. Cash-on-cash return calculates the annual return on the cash (or debt paid). Cap rates allow for analysis based on potential returns, while cash-on-cash is the actual return after cash is spent. They have different use cases, so it’s not one or the other. Both are important in real estate investment.
Regardless of the type, condition, location, or class of a property, a holistic investment analysis will help your clients make the most informed decision.
Finding the right cap rate for your goals
Defining the ideal cap rate is very subjective. Many things impact it that you can’t control. Understanding their calculation, meaning, and what influences them helps you use them as a screening tool for potential investments.
Ultimately, what makes it “good” depends on the specific goals and risk tolerance of the buyer. RentSpree has more resources on the topic of rental property investments:
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