What is a good cap rate? It depends on what you are buying

“What is a good cap rate?” is one of the most searched questions in real estate investing, and the honest answer is that there is no single number. A cap rate is the price the market puts on a stream of rental income, and that price depends on how safe, how stable, and how likely to grow the income is. A 5% cap rate can be a fair deal and a 10% cap rate can be a poor one.

A quick refresher on the formula

Cap rate = net operating income ÷ property value × 100. Net operating income (NOI) is a year’s rent, minus vacancy, minus operating costs such as tax, insurance, maintenance, and management. It leaves out the mortgage, so the cap rate describes the property, not the buyer’s loan. A building producing $30,000 of NOI and selling for $500,000 has a 6% cap rate.

Why a higher cap rate is not automatically better

For a buyer, a higher cap rate means more income per unit of price, so it is tempting to treat it as a score. But markets are rarely that generous. Cap rates are high when buyers demand extra income to compensate for something: an area with weak demand, an older building that will need major repairs, short leases, unreliable tenants, or rents that are expected to fall.

Cap rates are low when buyers are willing to accept less income today because they see less risk or more growth: a prime location, a new building, long leases with strong tenants, or a market where rents are rising. A low cap rate is the market saying “this income is safe and likely to grow”; a high one is the market saying “prove it.”

What moves cap rates

Location. Large, liquid cities with deep pools of buyers and tenants usually trade at lower cap rates than small towns, where a single employer leaving can empty a street.

Property type. Different kinds of property carry different risks. Apartments with many small tenants spread the risk of vacancy; a building with one commercial tenant is either fully let or completely empty.

Condition and age. A property that needs a new roof soon should trade at a higher cap rate, because part of its income will go straight back into the building.

Interest rates. Cap rates tend to follow the cost of borrowing and the yield on safe bonds, usually with a delay. When safe investments pay more, buyers demand more from property too, which pushes cap rates up and prices down.

Small changes, big price swings

Because value = NOI ÷ cap rate, a small change in the cap rate moves the price a lot. The same $30,000 of NOI is worth $600,000 at a 5% cap rate and $500,000 at a 6% cap rate. A one-point rise in the cap rate cut the value by about 17%, with no change in rent at all.

This works in both directions. Buying at a high cap rate and later selling when cap rates in the market have fallen (often called cap rate compression) can produce a large gain. Buying at a low cap rate leaves less room: if rates rise and cap rates follow, the value can fall even while the rent holds steady.

How to judge a cap rate in practice

Compare like with like. The useful comparison is with similar properties that recently sold in the same area. A cap rate that is well above them deserves an explanation before it deserves an offer.

Rebuild the NOI yourself. A listing’s cap rate is only as good as its NOI. Sellers sometimes leave out vacancy, management, or maintenance, which flatters the number. Recalculate with realistic costs before you compare.

Compare it with the cost of money. If you plan to borrow, the cap rate should be comfortably above the cost of the loan. When it is not, leverage reduces your cash return instead of increasing it — the cap rate vs. cash-on-cash return explainer walks through a worked example.

Look at the spread over safe yields. The gap between a property’s cap rate and the yield on government bonds is the extra income you get for owning a building instead of a risk-free asset. A thin spread means you are being paid little for the extra work and risk.

So, what is a good cap rate?

For most residential and commercial property, cap rates often fall somewhere between about 4% and 10%, with the lower end in prime, low-risk locations and the higher end in riskier markets or older buildings. A good cap rate is one that fairly pays you for the specific risks of the property in front of you, based on an NOI you have checked yourself, and that still leaves a positive margin over your cost of borrowing.

Work out a property’s cap rate with the cap rate calculator, or see how it combines with financing, rent growth, and appreciation in the property investment calculator.