How to calculate cap rate, step by step
To calculate cap rate, work out the NOI — the rent left after vacancy and operating expenses — then divide it by the property value and multiply by 100. A $350,000 property renting for $3,000 a month, 5% empty, with $9,000 of yearly expenses keeps $25,200 a year after the bills, and $25,200 divided by $350,000 is 7.20%. The whole method is five steps, and the only judgment in it is the vacancy rate and the expenses — the two numbers a seller is most likely to understate. Get those right and the cap rate is honest; get them wrong and it is a fantasy.
The worked example: $350,000, $3,000 a month, 5% vacancy, $9,000 expenses
Step 1 — write down the rent: $3,000 a month. Step 2 — work out the gross rent for the year: $3,000 times 12 is $36,000. Step 3 — take off the vacancy: 5% of $36,000 is $1,800, so the effective gross rent is $34,200. Step 4 — take off the operating expenses: $34,200 minus $9,000 is $25,200, and that is the NOI. Step 5 — divide the NOI by the value: $25,200 divided by $350,000 is 0.072, times 100 is 7.20%. The monthly NOI is $25,200 divided by 12, which is $2,100. The cap-rate-calculator does the same five steps for any property, with the branches that show what changes when any one of them moves.
What NOI is
NOI is net operating income: the rent a property keeps after vacancy and operating expenses, before the mortgage, income tax, and money set aside for big repairs. The gross rent is the headline number — $36,000 a year here — and it is the number a listing quotes. The effective gross is the rent actually collected: 5% vacancy costs $1,800 a year, so the effective gross is $34,200. The operating expenses are what it costs to run the property: tax, insurance, maintenance, management, and any utilities the landlord pays — $9,000 a year here. The mortgage is not deducted, because the cap rate is the return on the property, not on the money borrowed to buy it. And capital reserves — money set aside for a roof or a furnace — are not deducted either, because they are a choice about how to save, not a cost of running the property today.
What the cap rate tells you
The cap rate tells you how the price compares with the income, and nothing else. A 7.20% cap rate means the property earns $7.20 a year for every $100 of value, before financing. The same $25,200 NOI is a 10.08% cap rate on a $250,000 property and a 6.30% cap rate on a $400,000 one — the rent never changed, only the price. A higher cap rate means the property is cheaper next to its income; a lower one means it is dearer. But cheaper is not automatically better: a high cap rate in a weak area usually means the buyer is being paid to take the risk, and a low cap rate in a strong area usually means the buyer is paying for safety and growth. Compare cap rates only between similar properties in similar places, and always ask what rent and expenses sit behind them.
How to work backwards from a target cap rate
To find the price a target cap rate allows, divide the NOI by the rate: at an 8% target and a $25,200 NOI, the value is about $315,000 — pay more and the cap rate falls below the target. To find the rent a target rate needs, work the NOI backwards: an 8% cap rate on a $350,000 property needs a $28,000 NOI, so the effective gross has to be $37,000 after the $9,000 of expenses, and the rent has to be about $3,250 a month at 5% vacancy. A rent of about $3,500 a month lifts the cap rate further, to 8.83%. And to find the most the expenses can be at a target rate, take the NOI the rate needs off the effective gross: at 8% the expenses can be about $6,200 a year, against $9,000 on the defaults. The cap-rate-calculator works all three backwards — value, rent and expenses — for any target rate you type in.
What counts as a good cap rate
There is no single good cap rate. For a residential rental, 5% to 10% is the usual range: below 5% the property is dear next to its rent, above 10% it is cheap — or troubled. The range moves with the market: a strong city with rising rents can support a 5% cap rate, because the buyer expects the rent to grow; a slow town with flat rents needs 8% or 9%. It also moves with the property: a new building with a long-term tenant can trade at a lower cap rate than an old one with a short lease, because the income is safer. The honest question is never "is 7.20% good" but "is 7.20% good for this property, in this place, at this price". Answer it by comparing the cap rate with similar properties nearby, and by checking the vacancy and the expenses behind it. A 7.20% cap rate built on 0% vacancy and no expenses is not a 7.20% cap rate at all.
Common mistakes
The first mistake is using the gross rent instead of the NOI: $36,000 divided by $350,000 is 10.29%, and it looks wonderful until the vacancy and the expenses arrive. The second is forgetting vacancy altogether: a property empty for a month between tenants is about 8% vacant, not 0%. The third is using the price paid instead of the value today: a property bought for $250,000 ten years ago and worth $350,000 now earns its cap rate on $350,000. The fourth is counting the mortgage: the cap rate is unlevered, and deducting the mortgage payment turns it into cash flow, which belongs in the how-to-calculate-rental-property-roi guide, not here. And the fifth is comparing cap rates across different markets: a 7.20% cap rate in a growing city and a 7.20% cap rate in a shrinking town are not the same investment.
A quick check you can do in your head
You can sanity-check any cap rate without a calculator. First, the pieces must add up: $3,000 times 12 is $36,000, minus 5% vacancy is $34,200, minus $9,000 of expenses is $25,200, and $25,200 divided by $350,000 is 7.20%. Second, the rate must rise with the rent and fall with the value and the expenses: $2,500 a month gives 5.57%, $3,500 gives 8.83%, a $250,000 value gives 10.08%, and $12,000 of expenses gives 6.34%. Third, the backwards figures must line up: about $315,000 of value, about $3,250 a month of rent, and about $6,200 of expenses all give 8%. If a listing breaks any of these checks, the number is wrong — run your numbers through the cap-rate-calculator and compare them with the worked example above.