When you rent out a property, most of the world refers to the percentage of return you get every year as a rental yield, but here in the United States of America, we like to refer to it as a cap rate. Cap rate (capitalization rate) is one of the most commonly used metrics in real estate investing. It helps property owners and investors evaluate the potential profitability of a rental property and compare investment opportunities. That being said, it’s not a pure determining factor of a property’s success. Let’s break down what a cap rate is, why it’s important, and how you can improve it.
What is cap rate?
Cap rate is the percentage return an investor can expect to earn from a property, assuming it’s purchased with cash. It reflects the ratio of net operating income (NOI) to the property’s market value.
Cap rate formula:
How to calculate cap rate
Understanding how to calculate cap rate is essential for real estate investors looking to evaluate a property’s profitability. The formula itself is straightforward, but its application can differ depending on the type of property and rental strategy.
To illustrate this, we’ll walk through two real-world examples: one for a traditional long-term rental and another for a short-term rental property (Airbnb/VRBO). These examples will highlight how NOI, property value, and expenses influence cap rate calculations and how savvy use of tax strategies like depreciation and cost segregation can improve overall returns.
To understand the cap rate, you need to break it down into its components:
- Net Operating Income (NOI): Total rental income minus operating expenses (excluding mortgage payments).
- Property Value: The market value or purchase price of the property.
Example 1: Calculating cap rate for an Airbnb property
An investor purchases a short-term rental in Austin, TX, for $750,000 and rents it out on Airbnb. Here’s the breakdown of income and expenses:
| Income & Expenses | Annual Amount |
|---|---|
| Gross Rental Income | $120,000 |
| Property Management Fees | -$12,000 |
| Maintenance & Utilities | -$9,000 |
| Property Taxes & Insurance | -$8,000 |
| Total Operating Expenses | -$29,000 |
| Net Operating Income (NOI) | $91,000 |
This 12.1% cap rate suggests a high return, but short-term rentals come with seasonal fluctuations and higher operating expenses.
Example 2: Calculating cap rate for a rental property
Let’s say an investor is considering purchasing a rental property valued at $1,000,000. The property generates $50,000 in net operating income (NOI) per year after standard expenses such as property taxes and insurance.
This means the investor can expect an annual return of 5% on the property’s value before financing and taxes.
Breaking down the components
3. How property value affects cap rate
- If the property’s value rises to $1.2 million while NOI remains at $50,000, the cap rate drops:
This could indicate higher market appreciation but lower immediate returns.
- If the property value drops to $900,000, the cap rate improves:
This might signal a strong buying opportunity.
Real-world scenario: Cap rate for an Airbnb vs. a traditional rental
To see cap rate in action, let’s compare an Airbnb short-term rental and a traditional long-term rental.
- The Airbnb has a higher cap rate (12.0%) because it generates more income, but it also comes with higher management costs, occupancy risks, and seasonal fluctuations.
- The long-term rental has a more stable NOI, but a lower cap rate (6.1%).
How tax deductions affect cap rate in practice
If the Airbnb investor above used cost segregation, they could significantly reduce their taxable income, keeping more cash in hand and boosting their effective cap rate.
For example, if cost segregation lowers the property’s taxable income by $40,000 per year, the investor saves $12,000 in taxes (assuming a 30% tax bracket).
By reducing taxes, the investor effectively increased their cap rate by 1.4% without raising rent.
Why understanding cap rate can boost your profits
Cap rate is more than just a real estate metric; it’s a key indicator of profitability that helps investors evaluate and compare rental properties. A strong cap rate can mean higher returns, better cash flow, and smarter investment choices. That being said, it’s important to note here the
However, the real advantage comes when investors optimize their cap rate using tax strategies like accelerated depreciation and various writeoffs. which can reduce tax burdens and increase NOI. Let’s break down the biggest benefits of understanding and using cap rates effectively in real estate investing.
Using cap rate for smart investment decisions
- Quickly compare rental property investments
- Identify undervalued properties with higher potential ROI
- Assess risk levels based on cap rate trends in a given market
How can tax strategy improve cap rate?
Cost segregation studies help investors accelerate depreciation on their properties, lowering taxable income and increasing net cash flow. A higher NOI leads to a better cap rate and overall ROI.
Cost Segregation Impact on NOI
An investor owns a $1.2M rental property and generates $90,000 in annual NOI. Using traditional depreciation, they can deduct $30,000 per year. However, with cost segregation, they can accelerate depreciation, increasing their annual tax deduction to $80,000. This reduction in taxable income results in lower tax liability and more retained earnings, effectively increasing the property’s net income and cap rate.
The downsides of relying too much on cap rate
While cap rate is a valuable tool for assessing a property’s profitability, it’s not perfect. Real estate markets are complex, and cap rate alone doesn’t account for financing, tax benefits, or market fluctuations. Investors who rely solely on cap rate without considering these factors may end up misjudging an investment’s true potential.
One of the biggest mistakes investors make is overlooking the hidden costs of owning a rental property. Unexpected maintenance, seasonal vacancies, and failing to factor in cost segregation tax benefits can all throw off NOI calculations, leading to a misleading cap rate.
Limitations of Cap Rate
- Does not account for financing costs, such as mortgage payments or interest rates
- Market fluctuations can impact property values, making cap rates volatile
- Seasonal rental properties (like Airbnbs) often have fluctuating occupancy rates, which affect NOI and cap rate
- Failing to include tax benefits, such as those from cost segregation, in NOI calculations
Cap rate vs. other metrics: Which one tells the full story?
Cap rate is a useful starting point for evaluating rental property profitability, but it doesn’t account for factors like financing, appreciation, or long-term cash flow.
To get a full financial picture, investors should also consider cash-on-cash return, internal rate of return (IRR), and gross rent multiplier (GRM). These metrics provide a broader perspective, helping investors align properties with their financial goals.
The table below breaks down how these metrics compare and when to use each one.
| Metric | Definition | Best For |
|---|---|---|
| Cap Rate | NOI ÷ Property Value | Quick comparison of rental property profitability |
| Cash-on-Cash Return | Cash Flow ÷ Initial Investment | Evaluating leveraged returns (with financing) |
| Internal Rate of Return (IRR) | Expected annual return over time | Long-term investments |
| Gross Rent Multiplier (GRM) | Property Price ÷ Annual Rent | Comparing rental prices in a market |
We spoke to Elizabeth Alligood, a top real estate professional, about what else matters to real estate investors investing in property for rental yield.
“Homeowners can claim deductions for repairs and capital improvements, each with specific guidelines. Repairs that keep a property functional, such as fixing a roof, plumbing, or broken appliances, are tax-deductible but can only be written off in the year they occur. Capital improvements—like installing a new roof, adding an extension, or upgrading the HVAC system- are depreciated over time, as they increase the property’s value and extend its useful life.”
How to use cap rate when evaluating a rental property
Understanding cap rate is one thing—knowing how to apply it in real-world investment decisions is another. Cap rate can help investors quickly compare properties, assess risk, and estimate returns, but it should never be used in isolation.
The most successful real estate investors—especially those managing multiple rental properties or short-term rentals (Airbnb, VRBO, etc.)—know that cap rate is just one piece of the puzzle. They also consider cost segregation, financing options, and market trends to get the most accurate investment picture.
Here’s a step-by-step guide to using cap rate effectively when evaluating a rental property.
1. Gather financial data
Before calculating cap rate, you need two key numbers:
- Net Operating Income (NOI): This includes all rental income minus property management fees, maintenance, taxes, insurance, and other operational costs. It does not include mortgage payments.
- Market Value or Purchase Price: This is either the current appraised value of the property or the amount you’re paying to acquire it.
Example: Data collection for a rental property
Let’s say you’re evaluating a short-term rental in Nashville listed at $750,000. You estimate the following:
| Financial Factor | Annual Amount |
|---|---|
| Gross Rental Income | $120,000 |
| Property Management Fees | -$12,000 |
| Maintenance & Utilities | -$9,000 |
| Property Taxes & Insurance | -$8,000 |
| Total Operating Expenses | -$29,000 |
| Net Operating Income (NOI) | $91,000 |
2. Calculate cap rate
Once you have the NOI and property value, apply the cap rate formula, For the Nashville Airbnb example:
This means the property has a 12.1% cap rate, which suggests a high return. However, the investor should also account for higher operational risks, seasonal demand fluctuations, and management costs.
3. Compare against benchmarks
Cap rates vary depending on location, rental type, and market conditions. Here are some typical industry benchmarks:
| Property Type | Typical Cap Rate Range |
|---|---|
| Long-term rental (traditional leasing) | 4-6% |
| Short-term rental (Airbnb, VRBO) | 8-12% |
| Commercial real estate | 6-10% |
If your cap rate is too low, the property may be overpriced or have high operating costs. If it’s too high, it might indicate a higher investment risk or short-term rental volatility.
4. Look at methods to increase your cap rate by increasing your NOI
Once cap rate is calculated, the next step is optimizing net operating income (NOI) to improve profitability. Investors can do this by increasing revenue, cutting expenses, and taking advantage of tax breaks.
One of the most effective ways to boost NOI is to raise rental income, whether through strategic rent increases, offering furnished rentals at a premium, or improving amenities to attract higher-paying tenants. Reducing management costs, such as negotiating lower property management fees, handling maintenance in-house, or automating rent collection and bookings, also helps.
Beyond direct income and expense adjustments, tax strategies can further improve cap rate. Investors can lower taxable income through depreciation deductions, deduct property management and repair costs, and, in some cases, use cost segregation to accelerate depreciation on certain assets.
Speaking of tax strategies, we spoke to Louis Levine, of UK Expat mortgage, on their favorite tax strategies for their buyers in the US.
For those interested in community development, Opportunity Zone investments offer tax benefits when you reinvest capital gains into economically distressed areas. Delaware Statutory Trusts provide another option, allowing you to own a fraction of larger commercial properties while still qualifying for 1031 exchange benefits.
A more personal approach involves converting your rental into your primary residence for at least two years before selling, potentially qualifying you for substantial capital gains exclusions ($250,000 for individuals or $500,000 for married couples).
Example: How a tax strategy like cost segregation improves NOI through accelerated depreciation
An investor buys a $1.2 million rental property with an NOI of $90,000 per year. Without cost segregation, they take a standard $30,000 annual depreciation deduction, leaving them with a taxable income of $60,000.
By using cost segregation, they accelerate depreciation and increase their deduction to $80,000 per year, reducing taxable income to just $10,000.
| Factor | Without Cost Segregation | With Cost Segregation |
|---|---|---|
| NOI | $90,000 | $90,000 |
| Depreciation Deduction | -$30,000 | -$80,000 |
| Taxable Income | $60,000 | $10,000 |
5. Balance cap rate with other metrics
Cap rate is a great starting point, but smart investors look at multiple financial metrics before making an investment decision.
| Metric | What It Measures | Best For |
|---|---|---|
| Cap Rate | NOI ÷ Property Value | Quick profitability check |
| Cash-on-Cash Return | Cash Flow ÷ Initial Investment | Evaluating leveraged returns (with financing) |
| Internal Rate of Return (IRR) | Expected annual return over time | Long-term investments |
| Gross Rent Multiplier (GRM) | Property Price ÷ Annual Rent | Comparing rental prices in a market |
For example, an investor using financing should prioritize cash-on-cash return over cap rate, since mortgage payments aren’t reflected in NOI. Similarly, if they plan to hold the property long-term, IRR may be a better indicator of overall profitability.
Final thoughts: Cap rate is super valuable, but pay attention
Cap rate is a useful measure, but it shouldn’t be the only factor in evaluating a property. A high cap rate might look good on paper, but the investment could still carry significant risk if the market is in decline or the cash flow is unpredictable.
To make a smart decision, investors should look beyond cap rate and compare it to similar properties to get a clearer picture of value. Tax strategies like cost segregation can also help improve net operating income while reducing taxable income. Other financial metrics, like internal rate of return (IRR) and cash-on-cash return, provide a broader perspective on long-term profitability.
FAQ
How does cap rate differ from ROI in real estate investing?
Cap rate and ROI (Return on Investment) are often confused, but they measure different aspects of profitability. Cap rate focuses on the property’s income potential without considering financing, making it a good tool for comparing rental properties. ROI, on the other hand, takes into account the investor’s initial cash investment, including financing costs, which can give a more comprehensive view of long-term profitability.
Is a high cap rate always better for real estate investors?
Not necessarily. A high cap rate often indicates higher potential returns, but it can also signal greater risk. Properties with high cap rates may have higher vacancy rates, declining property values, or higher operating expenses. Investors should balance the cap rate with other metrics like cash-on-cash return, IRR, and market trends to ensure the investment aligns with their financial goals.
How can cost segregation affect a property’s resale value?
Cost segregation can increase cash flow during ownership by lowering taxable income, but it may also impact a property’s resale value. If an investor uses accelerated depreciation, the property might have a lower tax basis when sold, leading to higher capital gains taxes.
