Question 1

What is a cap rate?

Accepted Answer

Cap rate (capitalization rate) = Net Operating Income (NOI) / property value. It's the unlevered annual return an investor would earn buying the property all-cash, ignoring appreciation. NOI is gross potential rent minus vacancy/credit loss minus operating expenses (taxes, insurance, repairs, management, utilities) — but excludes debt service, depreciation, capital expenditures, and income taxes. Cap rate is the foundational metric for comparing income-producing properties.

Question 2

What is a 'good' cap rate?

Accepted Answer

Cap rate ranges depend on asset class, market, and risk. As of 2026, multifamily class-A in primary markets often trades at 4.5–5.5% caps; class-B/C in secondary markets at 6–8%; suburban office at 7–10%; industrial at 5–7% (compressed since 2021); retail strip centers at 6.5–8%. NCREIF Property Index quarterly reports publish current benchmarks. There's no universal 'good' — a 5% cap in a primary market with strong rent growth often beats an 8% cap in a declining tertiary market.

Question 3

How does the band-of-investment method derive a cap rate?

Accepted Answer

Band-of-investment treats cap rate as a weighted average of debt and equity returns: cap rate = (LTV × mortgage constant) + ((1 − LTV) × cash-on-cash equity yield). Mortgage constant = annual debt service / loan amount. Example: 70% LTV at 7% interest 25-year amortization gives a mortgage constant ~8.5%; 30% equity at 9% target cash-on-cash gives a weighted cap of (0.7 × 0.085) + (0.3 × 0.09) = 5.95% + 2.7% = 8.65%. The framework reveals why cap rate compression happens when rates fall — debt becomes cheaper, weighted-average required return falls, prices rise.

Question 4

When does cap rate break as a metric?

Accepted Answer

Three scenarios. (1) Tiny deals: a single-family rental's cap rate is dominated by repair-and-maintenance volatility — one $5K furnace replacement can swing the year's NOI 10–20%. Cash-on-cash and IRR become more useful. (2) Heavy-value-add or pre-stabilization deals: NOI today is below NOI at stabilization; using current NOI gives an artificially low cap rate that doesn't reflect economics post-rehab. Use stabilized NOI / total project cost. (3) Markets with significant rent growth or decline: a static cap rate ignores future rent trajectory; in fast-growing markets, a 4% cap with 5% annual rent growth beats a 7% cap with flat rents on 10-year IRR.

Question 5

What's the difference between cap rate and cash-on-cash return?

Accepted Answer

Cap rate is unlevered (assumes all-cash purchase). Cash-on-cash is levered: annual pre-tax cash flow / total cash invested (down payment + closing costs + initial repairs). On a property with positive leverage (cap rate > debt cost), cash-on-cash exceeds cap rate. On negative leverage, cash-on-cash is below cap rate. Both metrics matter: cap rate compares properties on equal footing; cash-on-cash measures what your specific cash actually earns given your specific financing.

Question 6

How do I compute NOI correctly?

Accepted Answer

NOI = Gross Potential Rent − Vacancy/Credit Loss − Operating Expenses. Operating expenses include: property taxes, insurance, property management (typically 8–10% of effective rent), repairs and maintenance (typically 5–10% of rent), utilities the landlord pays, HOA fees, marketing/leasing, accounting/legal. NOI EXCLUDES: debt service (mortgage P&I), depreciation, capital expenditures (roof, HVAC replacement, paving), and income taxes. The CapEx exclusion matters most — investors regularly inflate NOI by lumping CapEx into a 'reserve' that doesn't reduce NOI.

Question 7

Should I trust the cap rate the listing agent gives me?

Accepted Answer

No. Listing pro-formas systematically inflate NOI by understating vacancy (using 3% in markets where 7–8% is realistic), understating operating expenses (omitting management fees the listing assumes you'll self-manage, omitting CapEx reserves entirely, omitting actual tax bills post-sale at re-assessed values), and projecting rent growth into year-1 numbers. Always rebuild NOI from scratch using your own assumptions and the property's actual T-12 rent roll + actual expenses. The gap between listing cap rate and your underwritten cap rate is often 100–200 basis points.

Question 8

How does cap rate relate to discount rate / IRR?

Accepted Answer

Cap rate is an in-place, current-year, no-growth proxy for expected return. Discount rate / IRR is the return that equates the present value of all future cash flows (operating + sale) to the purchase price. The Gordon-growth-model relationship: cap rate ≈ discount rate − growth rate. So a 5% cap rate with 3% expected NOI growth implies an 8% discount rate. This is why low cap rates in growth markets are economically rational — and also why cap rate compression cycles can reverse violently when growth assumptions decompress.

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