The "Great" 5% Cap Rate That Almost Cost Me $300,000
A real estate agent told me a duplex had a "great" 5% cap rate. I almost bought it before running the actual numbers. The listing showed $2,400/month in gross rent on a $300,000 property. Sounds solid. But gross rent isn't net operating income — and that distinction is where deals go sideways.
After subtracting property taxes ($4,200/year), insurance ($1,800), maintenance reserves ($2,400), vacancy allowance ($1,440), and property management ($2,304), the actual NOI was $16,656 — not the $28,800 the agent implied by quoting gross rent.
OK, 5.55% isn't terrible. But the agent had been quoting a "cap rate" calculated from gross rent, which would have been 9.6%. That's not a cap rate. That's a fantasy.
What Cap Rate Actually Measures
Cap rate answers one question: if you bought this property with cash (no mortgage), what annual return would the rental income generate? It's the real estate equivalent of a bond yield — a snapshot of income relative to price.
The formula is simple. The inputs are where people get sloppy.
NOI = gross rental income minus all operating expenses (taxes, insurance, maintenance, vacancy, management). It does not include mortgage payments, capital expenditures, or depreciation. Those are financing and accounting decisions, not property performance metrics.
Two Properties, Two Markets, Same Cap Rate — Different Deals
Property A: a condo in San Francisco. $600,000 purchase price, $27,000 NOI. Cap rate: 4.5%.
Property B: a duplex in Memphis. $150,000 purchase price, $13,500 NOI. Cap rate: 9.0%.
Memphis looks like the obvious winner — double the cap rate. But cap rate doesn't tell the whole story.
| Factor | San Francisco (4.5%) | Memphis (9.0%) |
|---|---|---|
| Purchase price | $600,000 | $150,000 |
| Annual NOI | $27,000 | $13,500 |
| 5-year appreciation (est.) | +$120,000 (20%) | +$15,000 (10%) |
| Vacancy rate | 3% | 8% |
| Tenant quality | High-income professionals | Mixed |
| Management hassle | Low | Higher |
San Francisco's low cap rate reflects high demand, low risk, and strong appreciation potential. Memphis's high cap rate compensates for higher vacancy, more management headaches, and slower appreciation. Neither is objectively "better" — they're different risk-return profiles.
Low cap rate = expensive market, lower income yield, but usually safer and appreciating. High cap rate = cheaper market, higher income yield, but more risk and less appreciation. The cap rate is a thermometer, not a verdict.
Cap Rate vs. Cash-on-Cash Return: The Mortgage Factor
Cap rate assumes you paid cash. Most investors don't. Cash-on-cash return measures your actual return on the money you put in — the down payment plus closing costs.
Buy that Memphis duplex for $150,000 with 25% down ($37,500). Your mortgage payment is about $750/month. NOI is $13,500/year ($1,125/month). After the mortgage, your cash flow is $375/month or $4,500/year.
The cap rate was 9%. Your cash-on-cash return is 12% because leverage amplifies returns (and risk). This is why real estate investors obsess over financing terms — the mortgage math changes everything.
What's a "Good" Cap Rate?
It depends entirely on the market and property type. As of 2025:
3-5%
Class A / prime markets (SF, NYC, LA). Low risk, high appreciation.
5-8%
Class B / secondary markets. Balanced risk-return.
8-12%
Class C / tertiary markets. Higher yield, higher risk.
A 10% cap rate in San Francisco would signal something is very wrong with the property. A 4% cap rate in rural Mississippi would signal you're overpaying. Context is everything. Compare cap rates within the same market and property type, not across them.
The percentage change in cap rates over time also tells a story — falling cap rates mean prices are rising faster than rents (market heating up), and rising cap rates mean the opposite.
Frequently Asked Questions
What is a good cap rate for a rental property?
It depends on the market. In expensive coastal cities, 4-5% is typical. In the Midwest or South, 7-10% is common. Compare cap rates within the same market and property class. A "good" cap rate is one that compensates you fairly for the risk of that specific property in that specific location.
Does cap rate include mortgage payments?
No. Cap rate uses NOI (net operating income), which excludes mortgage payments, capital expenditures, and depreciation. It measures the property's income performance independent of how you financed it. For your actual return with a mortgage, use cash-on-cash return instead.
What's the difference between cap rate and ROI?
Cap rate measures annual income yield on the property's total value (assuming cash purchase). ROI measures total return including appreciation, tax benefits, and mortgage paydown over your entire holding period. Cap rate is a snapshot; ROI is the full movie. Both are useful, but they answer different questions.