If you’ve read even one property offering, you’ve probably seen the word cap rate thrown around. But what does it actually mean—and how should you use it?
Let’s break it down like you’re talking to your smartest friend over coffee.
📐 What Is Cap Rate?
Cap rate (short for capitalization rate) is a basic formula:
Cap Rate = Net Operating Income (NOI) ÷ Property Purchase Price
It tells you the unleveraged return you’d earn if you bought the property in cash.
Example:
If a property earns $120,000 per year in NOI and the price is $2 million,
→ Cap Rate = $120,000 ÷ $2,000,000 = 6%
🧠 What Does a Cap Rate Tell You?
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Risk Profile:
Higher cap rates often = higher risk. Lower cap rates = more stability. -
Market Sentiment:
In hot markets like Austin or Miami, cap rates are lower because investors accept smaller returns for safer bets. -
Price Evaluation:
A property with the same income but a higher cap rate may be undervalued.
⚠️ What Cap Rate Does Not Tell You
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It doesn’t account for financing or mortgage payments
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It ignores future value-add potential
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It doesn’t guarantee future performance—just reflects today’s numbers
🗺️ Use Cap Rate As a Compass, Not a Map
Instead of obsessing over “Is this cap rate good?”, ask:
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Is this cap rate normal for this area and asset class?
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Is the property’s NOI likely to go up or down?
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What are other properties in this market trading at?
A 4.5% cap rate in San Francisco might be fair. That same cap rate in a small town in Ohio? Huge red flag.
🎯 Final Thought
Cap rate is like the speedometer in your investment vehicle. It tells you how fast you’re moving relative to others—but not where you’re going or how safe the road is.
Use it wisely—alongside debt terms, growth strategy, and market comps—to make truly informed investment decisions.
