What is a cap rate? How to calculate it and what it tells you

The formula

Cap rate = net operating income (NOI) ÷ purchase price

NOI is the rent you actually collect minus the costs of running the property: property tax, insurance, repairs, management, and so on. It does not subtract mortgage payments. That's the point: cap rate describes the property, not the way you pay for it, so two buyers with different loans can compare the same building on equal terms. If you're not sure what goes into NOI, read how to calculate NOI first; the cap rate is only as good as the NOI you feed it.

A worked example

A duplex is listed at $250,000. Each side rents for $1,200 a month. You budget 5% for vacancy, 8% of rent for maintenance, 5% for capital expenses (roof, HVAC, water heaters), and 8% of collected rent for a property manager.

If the seller wants $280,000 instead, the same NOI gives a 5.7% cap rate. Cap rate and price move in opposite directions: pay more for the same income and your return goes down.

You can also run it backwards. If similar duplexes in the area trade around a 7% cap rate, this one's income supports a price of about $16,027 ÷ 0.07 ≈ $229,000. That's a useful sanity check on an asking price, as long as the NOI behind the comparison is calculated the same way.

What a cap rate tells you, and what it doesn't

A cap rate is good for:

• Comparing properties of different prices on one scale.
• Seeing how the market prices income in an area: lower cap rates usually mean buyers expect steadier rents, more appreciation, or less risk.
• Spotting asking prices that the rent can't support.

It leaves out:

• Financing. With a mortgage, your actual return on the cash you put in can be much higher or lower. That's what cash-on-cash return measures.
• Appreciation and loan paydown. Both add to total return over time but don't show up in one year's NOI.
• The future. A cap rate is a snapshot of one year. A property with below-market rents may have a low cap rate today and a much better one after leases renew.

What is a “good” cap rate?

There's no single number. Cap rates differ by city, neighborhood, property type and the interest-rate environment. A newer building in a high-demand area may trade at a lower cap rate than an older one in a slow-growing town, and both can be reasonable purchases for different investors. The more useful question is how a property's cap rate compares with similar properties nearby, and whether it's higher than your borrowing cost. When the cap rate is below your mortgage rate, borrowing more makes your cash flow worse, not better.

Common mistakes

• Trusting the listing's cap rate. Sellers often quote a cap rate built on full occupancy, no maintenance, and last decade's tax bill. Recalculate it with your own expenses.
• Using the seller's property tax. In many states the assessment resets when the property sells, and investors don't get homestead exemptions. Estimate tax at your purchase price.
• Subtracting the mortgage. That turns NOI into cash flow and makes the cap rate meaningless for comparison.
• Leaving out vacancy and capital expenses. Every property has turnover, and roofs wear out on their own schedule. Leaving them out flatters the number.
• Comparing across property types. A 6% cap rate on a single-family rental and on a strip mall reflect very different risks.

For a faster, rougher comparison that skips expenses entirely, see the gross rent multiplier.