What is cap rate, and why is it important for an investment property?

Capitalization rate (also known as cap rate) is the rate of return on a real estate investment.

While cap rate does not consider the impact of mortgage financing, a general rule of thumb is whether the cap rate is above or below the interest rate. If the cap rate is greater than the interest rate, you’ll generally come out ahead. If the cap rate is lower than the interest rate, you’ll be relying on appreciation for your return, making it a riskier speculative investment.

How to calculate cap rate on a rental property

The formula for cap rate is simple: income minus expenses, divided by the purchase price.

Sample cash flow analysis

Income, expense, and cap rate calculation for an investment property

Loan and purchase details
Target home purchase price
Down payment (%)
Down payment
Loan amount
Loan duration (y)
Annual interest rate
Initial one-time repairs/updates

Cost
$340,000
25%
$85,000
$255,000
30
4.7%
$15,000

Projected gross rental revenue
Property management fee rate

$54,630
31%

Annual expenses
Management fee (31% of $54,630)
HOA fees
Property taxes
Utilities1
Vacation rental insurance
Other

Total operating expenses

Cost
$16,935
$7,560
$3,804
$3,432
$400
$3,000

$35,131

Annual net operating income (NOI)2
Mortgage payment


Cash flow3

$19,499
-$16,025


$3,473

Cap rate4

5.73%

1. Electric, water, sewer, garbage, gas, cable, WiFi (annual)
2. Annual net operating income (NOI) is a unit’s projected rental revenue minus management fee and expenses (in this case, $54,630 - $35,131).
3. Projected cash flow before taxes: net operating income minus debt expense.
4. Cap rate: the potential rate of return on the real estate investment, calculated as net operating income (NOI) divided by the current market value (sales price) of the home (in this case, $19,499 / $340,000).

A business owner doing paperwork in their office

Download our real estate investment calculator

Try crunching the numbers. Our calculator (XLS) factors in cap rate, cash on cash, annual net operating income, and more.

How do you estimate vacation rental or Airbnb expenses and operating costs when determining cap rate?

A vacation home with low expenses and operating costs in a high-demand real estate market is likely to have a good cap rate. Expenses and operating costs will vary depending on a variety of factors, including location, the type of property you buy, and the method of property management you prefer (full-service or self-management).

When estimating your anticipated vacation rental expenses, don’t forget to factor in seasonal services that the property may require. For example, a four-bedroom beach house on the Gulf Coast may require additional maintenance due to wind, sand, and salt, whereas a four-bedroom cabin in Keystone, Colorado, may need regular snow shoveling or fallen tree removal services.

Take the time to figure utilities and taxes for each property when determining your expenses in vacation rental markets. Sometimes finding a better cap rate is as simple as searching for homes in lower-tax neighborhoods that still hold appeal for guests.

If you plan to host guests on a regular basis in your vacation home, you should expect a bit of wear and tear. Factoring in things like maintenance, replacement, and repair costs, you should budget around 5%–10% of your net rental income to cover updates. You can then factor in your mortgage.

The most variable expense to consider when determining cap rate is property management. If you plan to self-manage, you will need to account for everything from cleaning, maintenance, supplies, and marketing to guest support, accounting, and insurance. Or you can use a full-service vacation rental property manager, like Vacasa.

Working with a full-service property manager not only means someone else is doing all of this work for you, it also consolidates all of your property management expenses so that you can more easily factor cap rate.


Which is better: a higher cap rate or a lower cap rate?

A higher number is generally better when it comes to cap rate—but it’s not everything. If you’re deciding between a vacation rental property with a 6% cap rate and another with a 2% cap rate, you’ll get a higher return on investment with the 6% property. But there’s more to think about.

Cap rate doesn’t include things like potential equity growth or emotional value such as locking in a dream home for your retirement. Sometimes a home with a slightly lower cap rate is simply a better fit for you and your family.


What is a good cap rate for rental property?

What you’ll consider a good target cap rate will vary based on the market—due to differing rental demand, property types, and home prices. For example, for a large cabin in Moosehead Lake, Maine, you might be negotiating for 5% to 8% cap rates, whereas for a condo in Park City, Utah, you may be happy comparing properties in the 3% to 5% cap rate range.


Does cap rate take into account appreciation?

Cap rate doesn’t consider the benefits of potential appreciation. As a shortcut, you can add the anticipated appreciation to your cap rate to estimate your total return. A 5% cap rate and 5% appreciation gives a total return of 10%, comparing favorably to current interest rates and long-term stock market returns.


How is cap rate used in real estate?

Consider this example:

The Smith family wants to buy a four-bedroom vacation rental property near the beach. After speaking to rental property managers, they've determined the average operating cost for two four-bedroom townhomes in the neighborhood they want to buy.

Vacation home #1 is beachfront but in poor condition. The Smiths estimate they would need to invest about $100,000 into the home to make it vacation-rental ready. The home is on the market for $540,000 and the Smiths expect it to generate $40,000/year after operating costs. That's a cap rate of 6.2% ($40,000/$640,000).

Vacation home #2 is two blocks from the beach but features modern design and a hot tub. It costs $553,000 and is expected to generate $40,000 after operating costs. That's a cap rate of 7.2%.

Comparing cap rates alone, the Smith family sees that even though vacation home #2 is more expensive, it could provide them a better return on their investment. But that isn't their only consideration.

They could leverage the work that house #1 needs to negotiate a better price. For example, let’s say they’re able to negotiate the price of the sale down $100,000 to account for the $100,000 of upgrades they need to do. With the home price now at $440,000, their cap rate jumps to 7.4% ($40,000/$540,000), much closer to the earning potential of house #1.

To improve their cap rate for home #1 even further, they could transform the unfinished basement into another room for $10,000, bringing the earning potential of the home up from $40,000/year to $60,000/year. Factoring the additional construction cost for the new room into the home price means they’ll be investing a total of $550,000. But with the increased earning potential, their cap rate becomes 10.9%($60,000/$550,000)—their best option so far.

If they can’t negotiate, the Smiths will have to figure value beyond cap rate. For example, does owning beachfront property where they may someday retire warrant buying a home with slightly lower earning potential on the vacation rental market?


Can you find market cap rates for vacation rentals?

We compile market cap rates to help vacation rental property buyers find the markets that are delivering the best returns on investment. You can learn more about these markets in our Top 25 Best Places to Buy a Vacation Home report.

Knowing what a cap rate is and why it’s important will help you make a more informed decision when buying a vacation rental. And you don't have to be a real estate investor to understand the basics. Check out all of our tips on buying a vacation rental.


What is cash-on-cash return?

A related metric that considers mortgage financing is cash-on-cash return, which compares cash flows, minus financing expenses, with the down payment. Cash-on-cash returns just consider the difference between the income and the mortgage against the down payment, so they can be extremely sensitive to variations in performance.

For example:

$600,000 purchase price
$100,000 down payment
$1,800 monthly mortgage payment

Cap rate vs. cash-on-cash return

Income after expenses

Cap rate

Income after mortgage

Cash-on-cash return

$18,000

3%

($3,600)

(3.6%)

$24,000

4%

$2,400

2.4%

$30,000

5%

$8,400

8.4%

$36,000

6%

$14,400

14.4%

$42,000

7%

$20,400

20.4%

Vacation rental cap rate FAQ

Cap rate (short for capitalization rate) is the ratio of your net operating income to the purchase price of a rental property. In short, it's the rate of return on a real estate investment, like a vacation home or an Airbnb investment property.

When calculating cap rate, first take your annual net operating income and subtract your annual expenses. Then, divide that number by the purchase price of your vacation rental property.

No, the cap rate calculation does not include your mortgage payments. The formula for calculating cap rate includes your annual net operating income, minus annual expenses other than your mortgage. (Then, you'll divide that number by the home price to get your cap rate.)

A vacation rental property with a 7.5% cap rate has an annual net operating income that's 7.5% of the home's purchase price. So, for instance, a $250,000 home with an NOI of $18,750 has a 7.5% cap rate.

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Vacasa offers property management and other real estate services directly through Vacasa LLC and through Vacasa LLC's licensed subsidiaries. Click here for more information about Vacasa's licensed real estate brokerage/property manager in your state. Vacasa’s licensed real estate brokerages/property managers include: Vacasa Alabama LLC; Vacasa Arizona LLC; Vacasa Delaware LLC, 302-541-8999; Vacasa Florida LLC; Vacasa Louisiana LLC, Dana MacCord, Principal Broker, ph 504.252.0155 (Licensed in LA); Vacasa Michigan LLC, 947-800-5979; Vacasa Missouri LLC, Susan Scanlon, Designated Broker; Vacasa Nevada LLC; Vacasa New Hampshire LLC, P.O. Box 283, Conway NH 03818, Dave Grant, Broker of Record; Vacasa New Mexico LLC, 503-345-9399; Vacasa New York LLC, 888-433-0068, Susan E. Scanlon, Real Estate Broker; Vacasa North Carolina LLC; Vacasa Pennsylvania LLC; Vacasa Real Estate Corporation, California DRE #02105811, Joseph Czapkowicz, California DRE #01380722; Vacation Palm Springs Real Estate, Inc., California DRE #01523013, Joseph Czapkowicz, California DRE #01380722; Vacasa Real Estate LLC (licensed in Colorado, Daned Kirkham); Vacasa Real Estate LLC (licensed in Idaho, Oregon, and Utah); Vacasa Real Estate LLC (licensed in Tennessee, 615-671-9916); Vacasa Real Estate LLC (licensed in Texas, Debra Brock, Designated Broker); Vacasa Real Estate LLC (licensed in Washington, Robert Brush, Designated Broker); Vacasa Seasonals Inc., California DRE #02160171, Daned Kirkham, California DRE #01424621; Vacasa South Carolina LLC; Vacasa Tennessee LLC; Vacasa Vacation Rentals of Hawaii LLC, 3350 Lower Honoapiilani Road, Suite 600, Lahaina, HI 96761; Vacasa Vacation Rentals of Montana LLC, Patrice Tompkins, Licensed Property Manager; Vacasa Virginia LLC; Vacasa Wisconsin LLC; Vacasa Wyoming LLC. In Canada, this advertisement is provided by Vacasa Canada ULC, CPBC lic. number 75826, 172 Asher Rd. V1X 3H6 Kelowna, BC.

This document is informational and illustrative in nature and is not intended to constitute investment advice.