Cap rate

Cap rate, short for capitalization rate, compares the income of a property with its value. The formula is net operating income for the year divided by the property's value. As an illustration, a home that earns $24,000 of net operating income and is worth $400,000 has a cap rate of 6%. These numbers are an example only.

Cap rate ignores your mortgage. Two owners of the same home with different loans have the same cap rate but different cash flow. That is both its strength and its limit. It lets you compare properties on equal terms, but it does not show what you keep after loan payments.

Use it as one tool. A higher cap rate can mean higher income, or it can mean higher risk or more repairs ahead. A lower one can mean a stable, costly asset. Check the inputs: rent should be market rent and costs should include management and repairs. See our investor resources.