The Cap Rate Looks Great. But Is It Really?
A simple guide to understanding CAP rates and the numbers behind them.
When you're looking at an investment property, one of the first numbers you may notice is the CAP rate.
A property advertised with a 6%, 7%, or even 8% CAP rate can immediately look attractive. You may think:
“That sounds like a great deal.”
But before relying on that number, it is important to ask one question:
How was the CAP rate calculated?
A CAP rate can be a helpful tool for comparing investment properties. However, it is based on the property's income and operating expenses. If those numbers do not accurately reflect what the property will cost to operate, the CAP rate may not tell the whole story.
That is why investors should look beyond the number and understand what is behind it.
So, What Is a CAP Rate?
Let's keep it simple.
A CAP rate, short for capitalization rate, is a number investors use to estimate how much income a property produces compared to its value.
The basic formula is:
CAP Rate = Net Operating Income (NOI) ÷ Property Value
Net Operating Income may sound complicated, but the concept is straightforward.
NOI is the income a property produces after its normal operating expenses are paid.
For example, imagine a property valued at $1,000,000. After collecting rent and paying normal operating expenses, the property produces $60,000 in annual NOI.
The calculation would look like this:
$60,000 ÷ $1,000,000 = 6% CAP rate
The formula is simple. The more important point is that the CAP rate depends on the income and expenses used in the calculation.
If the income is overstated or the expenses are understated, the CAP rate can look higher than the property's actual performance may justify.
Why You Shouldn't Look at the CAP Rate Alone
Imagine you are comparing two properties. Both are priced at $1,000,000, and both generate $120,000 in annual income.
Property A
Income: $120,000
Expenses: $60,000
NOI: $60,000
CAP rate: 6%
Property B
Income: $120,000
Expenses: $40,000
NOI: $80,000
CAP rate: 8%
At first, Property B appears to be the better investment because it has the higher CAP rate.
However, the difference in expenses raises important questions:
Why are Property B's expenses so much lower?
Is the insurance cost current?
Could the property taxes change after the sale?
Does the current owner manage the property personally?
Did the property simply have an unusually low-maintenance year?
Are some expenses missing from the financial statements?
These questions do not automatically mean that something is wrong with Property B. They simply mean that the 8% CAP rate deserves a closer review.
The goal is not to assume the numbers are inaccurate. The goal is to understand the numbers before making a decision.
Look at the Property From the Future Owner's Point of View
One question can help you evaluate a property more realistically:
“What will this property cost me to operate?”
The current owner may operate the property differently than you plan to operate it after the purchase.
For example, the current owner may:
Manage the property personally
Have a long-standing insurance policy
Use preferred vendors
Handle certain repairs themselves
Have unusually low maintenance costs
Have different agreements with tenants
Pay certain expenses that are not clearly shown in the financial statements
Those expenses may be completely accurate for the current owner. However, they may not reflect the expenses you will have as the new owner.
When reviewing an investment property, try to build a realistic picture of what the property may look like after you purchase it.
Five Expenses You Should Always Review
You do not need to be a real estate expert to start asking the right questions. A good place to begin is by reviewing the property's major operating expenses.
1. Property Taxes
Start by reviewing the current property tax bill, but do not assume it will remain the same after the sale.
Ask:
“Could the property taxes change after the purchase?”
Depending on the property's location and local tax rules, a sale may lead to a change in the property's assessment or tax bill.
If property taxes increase, the property's operating expenses will also increase. That means less NOI and potentially a lower CAP rate.
Before relying on the current tax expense, find out how it was calculated and whether it is likely to change after the transaction.
2. Insurance
Insurance is another expense that deserves careful attention.
If the property shows a very low insurance cost, consider asking:
Is this the current insurance premium?
When was the policy last updated?
Has the premium increased recently?
Does the policy provide the coverage a new owner would need?
Would a new owner realistically pay a similar amount?
Insurance costs can change based on the property's location, age, condition, construction, claims history, and current market conditions.
An older financial statement may not accurately reflect the insurance cost you will face in the future.
3. Repairs and Maintenance
A low repair expense may make a property look more profitable. However, one low-maintenance year does not necessarily mean the building will always have low repair costs.
Consider the property's age and condition. Review major components such as:
The roof
Plumbing
Electrical systems
Heating and air conditioning
Exterior surfaces
Parking areas
Common areas
Appliances and other building systems
It is also helpful to review several years of repair history.
If repairs cost $30,000 one year and only $5,000 the next year, ask:
“Why was there such a large difference?”
The answer may reveal whether the lower expense is normal or whether it was simply an unusually good year.
4. Property Management
Property management is easy to overlook, especially when the current owner manages the property personally.
The financial statements may show:
Management expense: $0
That number may be accurate for the current owner. However, if you plan to hire a professional property management company, management will become a new operating expense.
When comparing properties, make sure you are comparing them based on a similar operating structure.
A property managed by the owner and a property managed by a professional company may have very different expense profiles, even if the buildings are similar.
5. Utilities and Other Operating Costs
Smaller recurring expenses can also affect the property's NOI.
Depending on the property, these costs may include:
Water
Sewer
Gas
Electricity
Trash
Landscaping
Cleaning
Pest control
Common-area maintenance
Administrative expenses
For each expense, ask:
“Who pays for this cost?”
Then ask:
“Is this expense included in the financial information I am reviewing?”
Sometimes an expense is not unusually low. It may simply be missing from the numbers.
Don't Just Look for Low Expenses. Look for Missing Expenses.
When reviewing a property's financials, do not only ask whether the expenses seem low.
Also ask:
“What expenses are missing?”
For example, the current owner may manage the property personally, which means there may be no management fee listed.
The owner may also handle certain maintenance tasks themselves, which could make repair expenses appear lower than they would be under professional management.
Other costs may be categorized differently, paid directly by the owner, or not clearly shown in a summary of the property's financials.
This does not automatically mean the numbers are wrong. It means you need to understand what is included, what is excluded, and what may change after the property changes hands.
One Year Doesn't Tell the Whole Story
A single year of financial information provides only a snapshot of the property's performance.
For example, a property may have one unusually strong year with:
Very few repairs
Low insurance costs
Minimal vacancy
Strong rent collections
Lower-than-normal operating expenses
That year could make the property appear more profitable than it normally is.
Reviewing three to five years of historical information can provide a more complete picture. When possible, compare:
Rental income
Vacancy
Property taxes
Insurance
Repairs and maintenance
Utilities
Management costs
Other recurring operating expenses
The goal is to identify patterns rather than focus only on the lowest expense shown.
If an expense changed significantly from one year to another, ask what caused the change and whether the current number is likely to continue.
The CAP Rate Can Change Quickly
Let's return to the $1,000,000 property.
The advertised financials show:
NOI: $80,000
Based on that NOI, the property has an:
8% CAP rate
That may sound attractive. However, after reviewing the expenses, you determine that your operating budget should include an additional $15,000 per year in costs.
The adjusted NOI would be:
$80,000 − $15,000 = $65,000 NOI
The adjusted CAP rate would be:
$65,000 ÷ $1,000,000 = 6.5% CAP rate
The property did not change. The purchase price did not change. The rental income did not change.
You simply developed a clearer understanding of the property's operating expenses.
That is why the advertised CAP rate should be treated as a starting point for further analysis, not as the final answer.
Does a Lower CAP Rate Mean It's a Bad Investment?
Not necessarily.
A lower CAP rate does not automatically mean that a property is a bad investment. The property may have other characteristics that make it attractive, such as:
A strong location
Consistent rental demand
Opportunities to increase rents
Potential for property improvements
Better management opportunities
Long-term growth potential
The opposite is also true. A high CAP rate does not automatically mean that a property is a great investment.
A higher CAP rate may reflect:
Higher operating expenses
Deferred maintenance
Greater vacancy
Lower-quality tenants
Property condition concerns
Location-related risks
Income that may not be sustainable
The CAP rate is a starting point, not the whole story.
Five Simple Questions to Ask
Before relying on the CAP rate shown on a property listing, ask the following questions:
1. Are the income numbers based on actual rent collected?
The rent tenants are expected to pay may be different from the rent the owner actually collects.
2. Are the expenses realistic for me as the new owner?
The current owner may operate the property differently than you plan to operate it.
3. Could the property taxes or insurance costs change?
Current expenses may not reflect the costs you will have after the purchase.
4. Does the maintenance history make sense?
A low repair bill does not always mean that the building is low-maintenance.
5. What expenses are missing?
Sometimes the most important number is the one that does not appear in the financial statements.
The Strategic Growth Perspective
At Strategic Growth, we believe that evaluating an investment property requires more than looking at the number on the listing.
The CAP rate is useful, but it is only one part of the overall picture.
A complete review should include:
The property's income
Its operating expenses
Its historical financial performance
Its physical condition
Its management structure
Its future operating needs
Most importantly, investors should consider what the property may look like after they become the owner.
A property is not just a CAP rate on a spreadsheet. It is a real building with real tenants, real repairs, real insurance costs, real property taxes, and real operating responsibilities.
Don't just look at the number. Understand what's behind it.
Want to Look Beyond the Numbers?
Whether you are considering buying a multifamily property or already own one, understanding the property's income and expenses can help you make more informed decisions.
At Strategic Growth, our experience in both real estate and property management gives us a practical perspective on what it takes to operate a property day to day.
If you are evaluating a property and want to better understand the numbers behind it, our team is here to help.
Disclaimer
This article is intended for general informational and educational purposes only. It is not intended to provide financial, investment, tax, legal, accounting, appraisal, or real estate advice. The examples in this article are hypothetical and are provided for educational purposes only. Actual property income, expenses, taxes, insurance costs, property values, CAP rates, and investment results can vary significantly. Readers should conduct their own independent due diligence and consult with appropriate qualified professionals before making any investment or real estate decision. Strategic Growth does not guarantee any particular investment result, return, property value, or future performance.
Sources & References
Fannie Mae Multifamily Guide — Net Operating Income (NOI)Guidance on calculating Net Operating Income and evaluating property income and operating expenses.
Fannie Mae Multifamily Guide — Income AnalysisGuidance on property income and common operating expenses, including management, insurance, utilities, repairs, and maintenance.
Freddie Mac Multifamily — Appraisal Guidance: Capitalization Rate DevelopmentInformation on capitalization rates and the use of actual and stabilized income and expense figures when evaluating multifamily properties.
Office of the Comptroller of the Currency (OCC) — Commercial Real Estate LendingGuidance on evaluating commercial real estate income, expenses, vacancy, capitalization rates, and expected property performance.
Sources are provided for educational reference and do not constitute an endorsement of any specific investment, property, or strategy.
