Cap Rate
One ratio lets you compare two rental properties on equal footing — even if one’s paid off in cash and the other’s financed to the hilt.
What Is It
Cap rate (capitalization rate) is a rental property’s Net Operating Income (NOI) divided by its purchase price or current market value, expressed as a percentage. NOI is rental income minus operating expenses — property tax, insurance, maintenance, management — but before mortgage payments. This is what makes cap rate distinct from other return metrics: it deliberately ignores financing. It also tends to move inversely with perceived risk and desirability — a property in a stable, in-demand market typically trades at a lower cap rate than a similar property somewhere riskier, since investors accept a lower return in exchange for more certainty.
Why It Matters
Because cap rate excludes the mortgage entirely, it lets an investor compare two properties purely on the property’s own performance — not on how much debt is used to buy it. A highly leveraged property and an all-cash property can have wildly different cash-on-cash returns for an investor, but the same cap rate, because cap rate measures the property, not the deal structure.
This makes it the standard first-pass metric for comparing rental properties against each other, before layering in financing decisions. It’s a screening tool, not a complete picture — two properties with identical cap rates can still differ substantially in appreciation potential, tenant quality, or how much ongoing attention they need, none of which shows up in the ratio itself.
Quick Example
A rental property purchased for $300,000 generates $24,000 a year in Net Operating Income (after expenses, before any mortgage payment). Cap rate = $24,000 ÷ $300,000 = 8%. A second property priced at $400,000 generating the same $24,000 NOI would have a lower 6% cap rate — a worse return on the property itself, regardless of how either one is financed. Whichever one an investor ultimately buys, cap rate alone already flagged which property is working harder for its price.
Run your own numbers: