Dec 26, 2026 · By Oanh Nguyen · Broker & Loan Officer · Investing
If you've looked at investment properties, you've probably seen the term cap rate. Listings mention it. Investors compare it. Some people treat it as the single number that decides whether a property is a good deal.
Cap rate is useful. But it's also easy to misuse. It leaves out financing, it depends on the accuracy of the income and expense numbers behind it, and it doesn't tell you everything about a property's future.
In this post, I'll explain what cap rate is, how to calculate it, what it includes and leaves out, how it differs from cash-on-cash return and cash flow after the mortgage, and the limits to keep in mind when you use it for Bay Area rentals.
This is general education, not investment, tax or legal advice. Talk with a CPA about taxes and a qualified advisor about your investment decisions.
What Is Cap Rate?
Cap rate, short for capitalization rate, compares a property's net operating income to its price or value.
Cap rate = Net operating income (NOI) ÷ Purchase price (or value)
It's shown as a percentage. It describes the property's income relative to its price as if you bought it with all cash, before any loan.
That's what makes cap rate useful for comparison. It describes the property itself, not the buyer's financing.
Step 1: Calculate Net Operating Income (NOI)
NOI is the property's yearly income after operating expenses, but before loan payments and income taxes.
Start with gross income:
- Scheduled rent for all units, for a year.
- Other income, like parking, storage or laundry, if any.
Subtract vacancy and credit loss:
- An allowance for times when units are empty or rent isn't collected.
Subtract operating expenses:
- Property taxes.
- Insurance.
- Repairs and maintenance.
- Property management, even if you plan to self-manage. Your time has value, and the next buyer may hire a manager.
- Utilities the owner pays.
- HOA dues, if any.
- Landscaping, pest control and other services.
- Reserves for replacements, like roofs, water heaters and appliances.
NOI = Gross income − Vacancy − Operating expenses
What NOI Leaves Out
These items are not part of NOI:
- Mortgage principal and interest.
- Income taxes.
- Depreciation, which is a tax concept. IRS Publication 527 explains depreciation for rental property.
- Large one-time capital improvements, though reserves for them should be included as an expense.
Because NOI leaves out financing, two investors with very different loans can look at the same property and see the same cap rate.
A Hypothetical Example
This example uses made-up, round numbers to show the math. It is not based on any real property and does not reflect typical Bay Area rents, prices or cap rates.
Imagine a property priced at $1,000,000.
| Line | Yearly amount |
|---|---|
| Gross scheduled rent | $60,000 |
| minus: Vacancy and credit loss | $3,000 |
| Effective gross income | $57,000 |
| minus: Property taxes | $12,000 |
| minus: Insurance | $2,500 |
| minus: Repairs and maintenance | $3,500 |
| minus: Property management | $4,000 |
| minus: Other operating costs and reserves | $3,000 |
| Net operating income (NOI) | $32,000 |
Cap rate = $32,000 ÷ $1,000,000 = 3.2%
Notice what happens if one assumption changes. If repairs are actually $3,000 higher, NOI drops to $29,000, and the cap rate becomes 2.9%. Small changes in expenses can change the result noticeably.
A California Detail: Property Taxes Reset
In California, property is generally reassessed when it's sold, under Proposition 13 rules. That means the seller's current property tax bill may be much lower than what a buyer will pay.
When you calculate NOI for a property you might buy, estimate property taxes based on your expected purchase price and the local tax rate, not the seller's current bill. The State Board of Equalization's Publication 29 explains how California property taxes work.
This is one of the most common mistakes I see in investor analysis.
Cap Rate vs. Cash-on-Cash Return
Cap rate describes the property, as if bought with all cash.
Cash-on-cash return describes your cash return, after financing.
Cash-on-cash return = Yearly cash flow after loan payments ÷ Total cash invested
Where:
- Yearly cash flow after loan payments = NOI − yearly loan payments (principal and interest).
- Total cash invested = down payment + closing costs + upfront repairs + other cash you put in.
| Cap rate | Cash-on-cash return | |
|---|---|---|
| Includes financing? | No | Yes |
| Describes | The property | Your investment |
| Changes with loan terms? | No | Yes |
| Useful for | Comparing properties | Comparing your cash returns |
Two buyers can buy the same property with the same cap rate and get very different cash-on-cash returns, depending on their loan terms and how much cash they put in. My post on how financing affects returns explains this further.
Cap Rate vs. Cash Flow After the Mortgage
Cash flow after the mortgage is the actual money left each month or year after you pay operating expenses and your loan payment.
A property can have a positive NOI and still have negative cash flow after the mortgage, if loan payments are higher than NOI. In high-price markets like much of the Bay Area, this is something investors should check carefully.
A simple worksheet:
| Line | Monthly | Yearly |
|---|---|---|
| NOI | $ | $ |
| minus: Loan principal and interest | $ | $ |
| Cash flow after mortgage | $ | $ |
Your lender can give you loan terms for your situation. I don't quote rates or payments here because they change and depend on each borrower.
How Investors Use Cap Rate
- Comparing properties of a similar type in a similar area.
- Checking whether a price makes sense given the property's income.
- Spotting unrealistic numbers. If a listing shows a cap rate that seems too high for the area, look closely at the income and expenses behind it.
- Tracking market trends in a specific property type over time, using reliable data.
The Limits of Cap Rate
Cap rate is a snapshot. Keep these limits in mind:
- It's only as good as the numbers. Listings may use optimistic rents or leave out expenses like management or reserves.
- It ignores financing. Your actual returns depend on your loan.
- It ignores future changes. Rent growth, expense increases, rent rules and property value changes aren't captured.
- It ignores property condition. A low-maintenance property and one with deferred repairs may show similar cap rates today.
- It ignores appreciation. In many Bay Area markets, investors also consider long-term value, which cap rate doesn't measure. My post on cash flow vs. appreciation covers this trade-off.
- Comparisons only work for similar properties. A single-family rental and a large apartment building in different cities aren't directly comparable.
- Local rules matter. Rent limits and tenant protections can affect future income.
Using Cap Rate the Other Way: Estimating Value
Some investors and appraisers flip the formula to estimate value from income.
Value = NOI ÷ Cap rate
Using the same made-up example: if a property's NOI is $32,000 and similar properties have recently sold at around a 3.2% cap rate, the formula points to a value near $1,000,000.
This approach is most common for larger income properties. For single-family homes and small rentals in the Bay Area, value is usually driven more by comparable sales, because many buyers are owner-occupants. Use the income approach as one view, not the only one.
Common Cap Rate Mistakes
- Using the seller's property tax bill instead of estimating taxes at your price.
- Leaving out management because you plan to self-manage.
- Skipping vacancy and reserves.
- Using projected rents without checking actual leases and local rules.
- Comparing different property types as if they were the same.
- Ignoring financing when deciding whether a deal works for you.
Checking a Listing's Cap Rate
When a listing advertises a cap rate, ask:
- Is it based on actual rents or projected "market" rents?
- Does it include vacancy?
- Does it include property management?
- Are property taxes based on the current owner's bill or a new purchase price?
- Are reserves for replacements included?
- Are insurance costs current?
- Can I see the rent roll, leases and expense records?
Rebuilding NOI with your own numbers is often the most useful step. My post on analyzing a rental property has a full worksheet.
Cap Rate Worksheet
| Line | Yearly amount |
|---|---|
| Gross scheduled rent | $ |
| plus: Other income | $ |
| minus: Vacancy and credit loss | $ |
| Effective gross income | $ |
| minus: Property taxes (based on your price) | $ |
| minus: Insurance | $ |
| minus: Repairs and maintenance | $ |
| minus: Property management | $ |
| minus: Utilities paid by owner | $ |
| minus: HOA dues | $ |
| minus: Reserves | $ |
| minus: Other operating expenses | $ |
| NOI | $ |
| Purchase price | $ |
| Cap rate (NOI ÷ Price) | % |
Key Takeaways
- Cap rate = NOI ÷ price, as if bought with all cash.
- NOI excludes loan payments, income taxes and depreciation.
- Use your own property tax estimate in California, not the seller's bill.
- Cash-on-cash return and cash flow after the mortgage include financing.
- Cap rate is a starting point, not the full picture.
Frequently Asked Questions
What is a good cap rate?
There's no single answer. It depends on the property type, location, condition, risk and market. Compare similar properties in similar areas.
Does cap rate include the mortgage?
No. Cap rate is calculated before loan payments.
What's the difference between cap rate and ROI?
Cap rate describes the property's income relative to price. ROI and cash-on-cash return describe your return, often including financing and other factors.
Why do cap rates differ between areas?
Cap rates reflect the relationship between prices and income, plus how investors see risk and long-term value in each area. Check current local data and compare similar properties.
Should I trust the cap rate in a listing?
Use it as a starting point. Rebuild NOI with your own numbers and verified records.
Is depreciation part of NOI?
No. Depreciation is a tax item. Talk with your CPA.
Can a property with a positive NOI lose money each month?
Yes, if loan payments are higher than NOI. Check cash flow after the mortgage.
Do I need a cap rate for a single-family rental?
It can still help compare options, along with cash flow and long-term considerations.
Does a higher cap rate mean a better deal?
Not always. A higher cap rate can reflect more risk, an older building, a weaker location or optimistic income numbers. Look at the reasons behind it.
How often should I recalculate cap rate?
Whenever rents, expenses or the price change, and at least once a year for properties you own.
How I Can Help
As a broker and loan officer, I help investors rebuild NOI with realistic numbers, estimate property taxes based on purchase price and compare cap rate, cash-on-cash return and cash flow after the mortgage side by side. I'll also connect you with a CPA for tax questions.
The Bottom Line
Cap rate is a simple, useful way to compare a property's income to its price. But it leaves out financing, depends on accurate numbers and doesn't measure future changes. Use it alongside cash-on-cash return, cash flow after the mortgage and a careful look at the property itself.
Analyzing a rental property? Let's run the numbers together with realistic income and expenses.
Sources
- IRS Publication 527, Residential Rental Property: https://www.irs.gov/publications/p527
- IRS Publication 946, How to Depreciate Property: https://www.irs.gov/publications/p946
- California State Board of Equalization, California Property Tax: An Overview, Publication 29: https://www.boe.ca.gov/proptaxes/pdf/pub29.pdf
- California Attorney General, Limits on Rent Increases: https://oag.ca.gov/rentcaps
Get help analyzing a rental property. Call or text me at 408-780-1188, or email onrealtygroup@gmail.com.
Oanh Nguyen · Broker & Loan Officer · On Realty Group, brokered by LPT Realty · BRE #02133991 · NMLS 2020335
Equal Housing Opportunity.
Loan disclosure: Oanh Nguyen, Broker | Loan Officer, On Realty Group, brokered by LPT Realty, BRE #02133991, NMLS #2020335. This post is general education, not a loan offer, rate quote or commitment to lend. Loan programs, guidelines and eligibility change and are subject to lender review and approval.
Disclaimer: This post is general information only, not an appraisal or legal, tax or financial advice; data comes from the public sources linked above, is believed reliable but not guaranteed, and can change at any time.