$1,000,000 property. $70,000 in annual income. 7% cap rate. That is the whole formula.
Here is what it means.
Cap rate (short for capitalization rate) is the yield a property generates on day one, assuming you paid all cash.
The formula: take the property's annual net operating income (rent minus expenses, before any debt) and divide it by the purchase price. That number is your cap rate.
Here is what a cap rate tells you:
- Whether you are being compensated for the risk you are taking
- How this asset compares to others in the same market
- What the market believes about the stability and growth of the income
Here is what it does not tell you:
- What you will actually earn on your invested cash (that requires factoring in debt, more on debt and capital stacks later)
- Whether the income is stable, growing, or about to fall apart
- Whether the asset will appreciate
Cap rate is a snapshot. Today's yield. Not tomorrow's value.
A low cap rate is not automatically bad. Trophy assets in tight, supply constrained markets trade at low cap rates because buyers accept a lower yield in exchange for stability and long-term upside. When I buy IOS assets, we look for cap rates north of 7.25% to compensate for the single tenant risk, balanced by the fact that we only buy in infill, supply-constrained markets.
A high cap rate is not automatically good either. High cap rates often signal risk: weak demand, questionable tenants, deferred maintenance, or a location nobody wants.
It is not just about the number. It is about what is driving it.
What cap rate question has never been fully explained to you?
Wednesday Real Estate 101: The cap rate
