How to Calculate Cap Rate on a Rental Property (And What It Doesn't Tell You)
Cap rate is NOI divided by price. The hard part is getting NOI right. Here's a worked example, how to turn a target cap rate into an offer price, and where the number misleads.
Cap rate is one of the first numbers people quote about a rental, and one of the easiest to get wrong. The formula is simple. The hard part is the number you put on top of it.
Cap rate = net operating income (NOI) ÷ purchase price
This guide walks through how to calculate NOI honestly, a worked example, how to use cap rate to set an offer price, and what cap rate leaves out. If you'd rather skip the arithmetic, use the free cap rate calculator.
General education only, not financial or tax advice.
Step 1: Start with gross scheduled income
Add up a full year of rent for every unit at current or realistic market rent, plus any other regular income such as parking, laundry, storage or pet rent.
Use rent you can actually verify. A seller's "pro forma" rent is a projection, not a fact. Check it against current leases and comparable rentals before you rely on it.
Step 2: Subtract vacancy to get effective gross income
No rental is occupied 100% of the time. Subtract an allowance for vacancy and unpaid rent. The right percentage depends on your market and the property, so base it on local turnover, not on what makes the deal work.
Effective gross income (EGI) = gross scheduled income − vacancy and credit loss
Step 3: Subtract operating expenses to get NOI
Operating expenses are the costs of running the property:
- Property taxes (estimate what they'll be after the sale if your area reassesses on purchase, not the seller's current bill)
- Insurance
- Repairs and maintenance
- CapEx reserves for roofs, HVAC, water heaters and other big replacements (see how much CapEx reserve per unit)
- Property management, even if you self-manage (your time has a cost, and you may hire a manager later)
- Owner-paid utilities, trash, HOA dues, landscaping, snow removal, pest control
- Leasing costs, legal and accounting
What's not an operating expense:
- Mortgage principal and interest. Cap rate measures the property, not your loan.
- Depreciation. It matters for taxes, but it isn't a cash cost.
- One-time renovation costs you plan right after buying. Budget those separately.
NOI = EGI − operating expenses
Step 4: Divide by price
Cap rate = annual NOI ÷ purchase price
A worked example (hypothetical numbers)
A duplex is listed at $300,000. Each side rents for $1,250 a month.
| Line | Annual amount |
|---|---|
| Gross scheduled income ($2,500 × 12) | $30,000 |
| Vacancy allowance (5%) | −$1,500 |
| Effective gross income | $28,500 |
| Repairs (5% of rent) | $1,500 |
| CapEx reserve (5% of rent) | $1,500 |
| Management (8% of rent) | $2,400 |
| Property taxes | $3,600 |
| Insurance | $1,500 |
| Total operating expenses | $10,500 |
| NOI | $18,000 |
Cap rate = $18,000 ÷ $300,000 = 6.0%
Now suppose the listing says "8% cap rate." Working backwards, that implies an NOI of $24,000, which would mean only $4,500 of expenses on this property, or rents nobody has verified. That gap is exactly why you calculate your own NOI instead of trusting the advertised one.
Using cap rate to set an offer price
Flip the formula around and cap rate becomes a pricing tool:
Price = NOI ÷ target cap rate
If you've decided this duplex needs to hit a 7% cap rate to be worth buying, then $18,000 ÷ 0.07 ≈ $257,000 is the price that gets you there. That doesn't mean the seller will take it, but it tells you where your numbers stop working before you start negotiating.
Your target is your call. It should reflect your market, the property's condition and risk, and what else you could do with the money. There's no universal "good" cap rate.
What cap rate doesn't tell you
- Financing. Two buyers can pay the same price for the same property and get very different results depending on their loan. For that, use cash-on-cash return and monthly cash flow.
- Appreciation and rent growth. Cap rate is a snapshot of one year's income.
- Big repairs coming soon. A building with a 25-year-old roof and a new one can show the same NOI this year.
- Tax effects. Depreciation and your own tax situation aren't in it.
Cap rate works best as a quick, apples-to-apples comparison between similar properties, as long as every NOI was calculated the same way. For a fast first screen before you even get to NOI, see the 1% rule.
Common cap rate mistakes
- Using the seller's expense numbers without checking them. Ask for actual bills and the trailing 12 months of income and expenses.
- Leaving out vacancy, CapEx or management. Each one quietly inflates the cap rate.
- Using today's property tax bill when the purchase will trigger a reassessment.
- Subtracting the mortgage. That's cash flow, not NOI.
- Comparing cap rates calculated different ways. Recalculate every deal with the same assumptions.
Run the numbers
- Quick check: the free cap rate calculator and cash-on-cash return calculator.
- Full analysis: the Rental Deal Analyzer ($19) calculates cap rate, cash flow and cash-on-cash return with a five-year projection and side-by-side deal comparison. Rehabbing first? Use the BRRRR & Flip Analyzer ($24). Get both in the Investor Pack ($39).
- See the math applied to real-style listings in Deal of the Week.
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Jon, Everyone's Landlord