A cap rate is a property's annual net operating income (NOI) divided by its value, expressed as a percentage — it estimates the unleveraged yield of a rental property. To calculate it, divide NOI (gross rent minus operating expenses, excluding the mortgage) by the purchase price and multiply by 100. For example, a $285,000 property earning $20,040 in annual NOI has a 7.03% cap rate. You can also reverse the formula to find what a property is worth at a target cap rate.
Cap Rate Formula
The capitalization rate measures an investment property's potential return:
Cap Rate = NOI / Property Value × 100
Where NOI (Net Operating Income) = Gross Rental Income - Operating Expenses. Rearranged, the same formula values a property from a known cap rate: Property Value = NOI / Cap Rate.
Worked Example
Suppose you're evaluating a duplex listed at $285,000 that rents for $2,350 per month.
- Annualize gross income: $2,350 × 12 = $28,200 per year.
- Subtract operating expenses: taxes, insurance, management, maintenance, and vacancy total $680/month, or $8,160/year. NOI = $28,200 − $8,160 = $20,040.
- Divide NOI by value: $20,040 / $285,000 = 0.0703.
- Convert to a percentage: 0.0703 × 100 = 7.03% cap rate.
To work backward, fix a target cap rate instead. At a 6.5% cap rate, that same $20,040 NOI implies a value of $20,040 / 0.065 = $308,308. If the asking price falls below that figure, the property beats your target yield.
What Counts as Operating Expenses
| Included | Not Included |
|---|---|
| Property taxes | Mortgage payments |
| Insurance | Depreciation |
| Property management | Income taxes |
| Maintenance & repairs | Capital expenditures |
| Vacancy allowance | Loan origination fees |
| Utilities (if landlord-paid) | Personal expenses |
Cap Rate vs. Other Metrics
| Metric | Formula | Includes Financing |
|---|---|---|
| Cap Rate | NOI / Property Value | No |
| Cash-on-Cash Return | Cash Flow / Cash Invested | Yes |
| GRM (Gross Rent Multiplier) | Price / Gross Annual Rent | No |
| ROI | Total Return / Total Investment | Yes |
Factors That Affect Cap Rate
- Location: Properties in high-demand urban areas have lower cap rates (higher prices relative to rent)
- Property condition: Newer or renovated properties command lower cap rates
- Tenant quality: Long-term, creditworthy tenants reduce risk and cap rate
- Market conditions: Rising interest rates generally push cap rates higher
- Property type: Multifamily tends to have lower cap rates than retail or industrial