Real estate investors rely on a variety of metrics to evaluate opportunities—equity multiple, yield on cost, cash-on-cash return, internal rate of return, and plenty more—all designed to help assess and compare the risks and potential rewards of a given asset. One metric consistently used in real estate is the capitalization rate (or “cap rate”), a time-tested measure that provides a quick and effective way to compare opportunities across different property types and risk profiles.
Whether you’re new to multifamily investing or building a growing portfolio, understanding and paying attention to the cap rate at a given purchase price can help you spot value, assess risk, and make more informed investment decisions.
What is Capitalization Rate?
In simple terms, a cap rate shows how much money a property is expected to make compared to how much it costs to buy. It tells you how efficiently the property turns investment dollars into income at that point in time.
For investors, this means you get a clear, apples-to-apples way to compare properties, even if they vary in size, location, or purchase price. Cap rates distill layers of income and expense l data into a single, digestible metric, helping you assess whether the return on a property justifies its cost.
How is Capitalization Rate Calculated?
To calculate a cap rate accurately, you need two key numbers:
- Net Operating Income (NOI): This is the income the property generates after subtracting all operating expenses (but before factoring in mortgage payments or capital expenditures).
- Purchase Price: What you’re paying for the property.
Cap Rate = Net Operating Income / Purchase Price
Let’s say a property earns $100,000 per year in net operating income and costs $1,000,000 to buy.
$100,000 / $1,000,000 = 0.10, or a 10% cap rate
So, if you paid for the property in full, you’d earn a 10% return annually, before financing costs and any capital expenditures.
That’s why cap rates are so important. They strip away financing variables and other inconsistent and/or one-time expenses and focus on the property’s core performance.
Why Cap Rate Matters for Investors
Using cap rates to compare multiple properties gives potential investors the ability to spot which ones offer the best in-place yield.
Besides offering a quick comparison, cap rates also allow you to identify the value of the property, assess its risk, and gain market insights.
For instance, a higher cap rate could suggest more risk, while a lower cap rate often signals a more stable, in-demand property. Investors can also use cap rates to evaluate if the asking price makes sense given the income the property produces.
Oftentimes, shifts in average cap rate can reveal broader trends in real estate values and investor sentiments.
What’s a “Good” Capitalization Rate?
It depends. There’s no perfect cap rate to watch for since context matters. What’s considered “good” varies based on the market, property type, and risk tolerance.
- Market: In a competitive city like San Jose or New York, 3-5% might be a normal cap rate. Whereas in some secondary or tertiary markets, 6-9% could be more common.
- Property type: Industrial, office, retail, and multifamily properties all have different expected returns. One standard rate can’t be used as a blanket “good” rate across all property types.
- Risk tolerance: Higher cap rates could indicate more income potential, but they also often come with greater risk, like older properties or higher tenant turnover.
The rule of thumb is that a higher cap rate equals a potentially higher return, but usually with a higher risk. A lower cap rate typically means it’s a more stable asset, but with less immediate income.
Why CEP Uses Cap Rate to Guide Investment Decisions
At CEP Multifamily, we use cap rates as a starting point to evaluate in-place yield and understand how a property fits into our broader investment strategy.
For our Core-Plus approach, we typically look for opportunities where a slightly higher cap rate (relative to like opportunities) signals both income potential and long-term upside. This helps us prioritize properties that steadily appreciate over time while avoiding excessive risk.
We also weigh a property’s cap rate alongside multiple other key metrics at the property-level, as well as those at the market-level like rent growth, absorption, and supply growth. Cap rates help us—and our investors—invest with clarity and confidence.
In real estate investing, clarity is everything. Cap rates offer a clear, consistent way to measure and compare income-producing properties, helping you find opportunities that align with your goals.
When used correctly, it can help you avoid overpriced properties, spot underperforming assets, and maximize your ROI with less guesswork.
Ready to invest smarter? Take the next step toward building long-term wealth by contacting our team.