Cap Rate Formula
The Cap Rate Formula divides the Net Operating Income (NOI) of a property by the current market value of the property.
- Cap Rate Formula = Net Operating Income / Property Value
What Is Net Operating Income?
The Net operating income (NOI) of the property is the income generated by the property, after subtracting all the expenses. It’s best to calculate NOI for the full year rather than a single month. You need to know the NOI in order to calculate the capitalization rate.
Net Operating Income = Annual Rental Income – Annual Operating Expenses
Net Operating Income Example
In the example below, we are going to demonstrate how to calculate net operating income for a property generating $2000 per month in rental income.
What Is The Current Market Value of the property?
The current market value is the price you would expect to pay for the property when applying the cap rate formula. Even though property prices are relatively stable, it makes sense to use up-to-date pricing data. You can get this from websites like Zillow, the New Silver ARV Calculator, or a local real estate agent.
To get an accurate estimate of the current market value, it’s best to use comparable properties (comps). A comp is a similar property to the one you are evaluating. Ideally, comps should be in close proximity to the target property, have similar square footage, and have a comparable number of bedrooms and bathrooms. This article provides an in-depth breakdown of how to get comps on a house.
How To Calculate Cap Rate: Step-By-Step
The cap rate formula is straightforward:
Cap Rate = Net Operating Income (NOI) ÷ Current Market Value
Applying it correctly depends on getting two inputs right: your NOI and your property value. Here's how to work through each step.
Step 1: Calculate Your Annual Rental Income
Start with the gross rental income the property generates over a full year. If the property rents for $2,000 per month, your annual gross rental income is $24,000. If the property has multiple units, add the annual income from each unit together.
Step 2: Account for Vacancy
No property is occupied 100% of the time. A standard vacancy allowance is 5–10% for residential properties, though this varies by market. Subtract this from your gross income to get a more realistic income figure.
For a property generating $24,000 annually with a 5% vacancy allowance:
$24,000 × 0.95 = $22,800 effective rental income
Step 3: Subtract Operating Expenses to Get NOI
Operating expenses reduce your income to a net figure. The following expenses are included in the cap rate calculation:
- Property taxes
- Insurance premiums
- Property management fees
- Routine maintenance and repairs
- Utilities (where landlord-paid)
- Legal and accounting fees
The following are excluded. Do not subtract these when calculating NOI:
- Mortgage payments (principal and interest)
- Depreciation
- Income taxes
This exclusion of debt payments is intentional. Cap rate measures the property's performance independent of how it is financed, making it a fair comparison tool across differently structured deals.
Example: Using $22,800 effective income with $5,600 in annual operating expenses: $22,800 − $5,600 = $17,200 NOI
Step 4: Determine Current Market Value
Use the current market value of the property, not what you paid for it if you have owned it for several years. You can estimate this using recent comparable sales (comps), a formal appraisal, or tools like the New Silver ARV Calculator.
For this example, the property's current market value is $215,000.
Step 5: Divide NOI by Market Value
$17,200 ÷ $215,000 = 0.08 = 8% cap rate
Cap Rate Calculation Example
To illustrate how quickly you can assess the profitability of two similar rental properties using the cap rate formula, we are now going to run through a simple example.
Quick Reminder: Cap Rate = Net Operating Income/Current Market Value
Property A
Property A Details:
- Net Operating Income: $18,000
- Current Market Value: $225,000
- Cap Rate Formula: $18,000/$225,000
- Cap Rate: 8%
Property B
Property B Details:
- Net Operating Income: $20,000
- Current Market Value: $307,700
- Cap Rate Formula: $20,000/$307,700
- Cap Rate: 6.5%
In this example, you can clearly see that Property A (8%) has a significantly higher cap rate than Property B (6.5%). All else being equal, it would make sense for a real estate investor to select property A in this case, provided their primary goal is to generate positive cash flow through rental income .
It is also worth noting that we have a very simple cap rate calculator that can help you work out the cap rate of other properties.
Cap Rate Comparison Table
To further illustrate the benefits of a higher cap rate (assuming everything else is equal), we have created a cap rate comparison table for a $200,000 property.
Cap Rate Comparison For $200,000 Home
| Net Operating Income | Property Value | Cap Rate |
|---|---|---|
| $4,000 | $200,000 | 2% |
| $6,000 | $200,000 | 3% |
| $8,000 | $200,000 | 4% |
| $10,000 | $200,000 | 5% |
| $12,000 | $200,000 | 6% |
| $14,000 | $200,000 | 7% |
| $16,000 | $200,000 | 8% |
| $18,000 | $200,000 | 9% |
| $20,000 | $200,000 | 10% |
As you can see, a higher cap rate means that you are generating a higher net income, relative to the value of the property. You could say that with a higher cap rate, the annual rental income covers a greater percentage of the property’s value. As a result, a higher cap rate means that the investment property will pay itself off faster.
How To Use Cap Rate To Workout Property Value
It is actually relatively simple to estimate property value using the cap rate formula. You simply need to swap the variables of the Cap rate Formula.
Current Market Value = Net Operating Income / Cap Rate
Example of How To Use Cap Rate To Determine Value
Property Details:
- Net Operating Income: $18,000
- Cap Rate: 8%
- Current Market Value = 18,000 / 0.08
- Current Market Value = $225,000
What Is A Good Cap Rate?
There is no single answer, because a good cap rate depends on the property type, location, and your own risk tolerance as an investor. That said, most real estate investors consider cap rates in the 4% to 10% range to be acceptable, with the sweet spot varying based on what you are buying and where. For a closer look at how cap rates vary across US markets, see our guide to US cities with the highest cap rates.
As a general principle, a lower cap rate signals lower risk and typically corresponds to higher-quality properties in stable, high-demand markets. A higher cap rate signals higher potential returns but also higher risk, often reflecting properties in less established markets or those requiring more active management.
Cap Rate Benchmarks by Property Type
The table below outlines typical cap rate ranges by property type. These are general benchmarks and will vary by market conditions, location, and the specific characteristics of a property. For institutional-grade commercial data, the National Council of Real Estate Investment Fiduciaries (NCREIF) publishes quarterly cap rate data by property type.
| Property Type | Typical Cap Rate Range | Notes |
|---|---|---|
| Single-family residential | 4% to 10% | Varies significantly by market |
| Multifamily (2–4 units) | 4% to 8% | Lower risk, strong financing options |
| Multifamily (5+ units) | 5% to 9% | Scales with vacancy risk |
| Commercial retail | 5% to 10% | Higher variance, tenant quality matters |
| Industrial | 4% to 8% | Strong fundamentals in recent years |
| Office | 6% to 12% | Elevated risk post-pandemic |
The Risk and Return Tradeoff
A useful way to think about cap rate is in relation to risk. A property with a 4% cap rate in a major city like New York or San Francisco is priced that way because demand is high, vacancy is low, and the asset is considered reliable. An investor accepts a lower return in exchange for stability.
A property with a 9% cap rate in a secondary market may generate more income relative to its price, but the investor is taking on more risk: potentially higher vacancy, more maintenance, and a thinner pool of future buyers.
Neither is inherently better. The right cap rate for you depends on your investment strategy and how much risk you are comfortable carrying.
Limitations of the Cap Rate Formula
Cap rate is a useful screening tool, but it has real limitations that every investor should understand before relying on it.
It does not account for financing
Because cap rate excludes mortgage payments, it tells you nothing about the actual cash flow you will receive as a leveraged investor. Two investors buying the same property at the same cap rate can have very different real-world returns depending on their loan terms, down payment, and interest rate. For a more complete picture of leveraged returns, look at cash-on-cash return alongside cap rate.
It assumes stable income
Cap rate works best for properties with predictable, consistent rental income. It's less useful for short-term rentals, vacation properties, or properties undergoing renovation, where income fluctuates significantly from month to month or year to year.
It's a snapshot, not a forecast
Cap rate reflects current income and current value. It does not account for future rent growth, planned improvements, or changing market conditions. A property with a modest cap rate today could become significantly more valuable if rents rise or the surrounding area appreciates.
It does not capture all costs
Cap rate uses operating expenses, but it doesn't factor in capital expenditures such as roof replacements, HVAC systems, or major structural repairs. These costs can materially affect the true return of a property over a longer holding period.
When not to use cap rate
Cap rate is generally not appropriate for the following investment types:
- Fix and flip investments, which generate returns through appreciation and resale rather than rental income
- Properties with no rental history, where income projections are speculative
- Short-term vacation rentals with highly seasonal income patterns
Used with an awareness of these limitations, cap rate remains one of the most efficient tools available for quickly comparing income-producing properties.
Cap Rate vs Other Real Estate Metrics
| Metric | Includes Financing? | Best Used For |
|---|---|---|
| Cap rate | No | Comparing properties on equal footing |
| ROI | Yes | Measuring return on a specific deal |
| Cash-on-cash return | Yes | Actual annual cash flow after debt service |
| Gross rent multiplier | No | Quick initial property screen |
| DSCR | Yes | Assessing loan eligibility |
Cap rate is one of several metrics investors use to evaluate rental properties. Here’s how it compares to the most common alternatives.
Cap Rate vs ROI
Return on investment (ROI) and cap rate both measure profitability, but they are not interchangeable. Cap rate measures a property’s income potential independent of financing. ROI factors in how the deal is structured, including your down payment, loan costs, and any money spent on improvements. This makes ROI more useful for understanding your personal return on a specific deal, while cap rate is better for comparing properties on a level playing field. For a deeper look at how these two metrics differ, see our guide to cap rate vs ROI.
Cap Rate vs Cash-on-Cash Return
Cash-on-cash return measures the annual cash flow you receive relative to the actual cash you invested, including your down payment and closing costs. Unlike cap rate, it accounts for your mortgage payments. If you are financing a property, cash-on-cash return gives you a more accurate picture of what you will actually pocket each year. Cap rate is better for comparing properties before financing decisions are made. Read more in our full comparison of cash-on-cash return vs cap rate.
Cap Rate vs Gross Rent Multiplier (GRM)
The gross rent multiplier is calculated by dividing the property’s purchase price by its gross annual rental income. It’s a faster calculation than cap rate because it doesn’t require expense data, making it useful for a very quick initial screen. However, it’s also less accurate because it ignores operating costs entirely. Think of GRM as a rough filter and cap rate as the more reliable follow-up calculation.
Cap Rate vs Debt Service Coverage Ratio (DSCR)
The debt service coverage ratio measures whether a property’s income is sufficient to cover its mortgage payments. Lenders use it to assess loan eligibility, typically requiring a DSCR of 1.25 or higher. While cap rate helps you evaluate a property’s return potential, DSCR helps you understand whether a lender will finance it. The two metrics serve different purposes and are most useful when considered together. Use our DSCR Calculator to run the numbers on your next deal.
Final Thoughts
In this post, we have provided a simple summary of the Cap Rate Formula, together with some step-by-step examples to demonstrate exactly how to use the formula.
Our hope is that you now have a better understanding of what cap rate is and how to compare two or more real estate investment properties using this relatively straightforward calculation.
Frequently Asked Questions (FAQ)
Divide the property’s net operating income (NOI) by its current market value, then multiply by 100 to express the result as a percentage. For example, a property with an NOI of $18,000 and a market value of $225,000 has a cap rate of 8%. For a full walkthrough of each step, see the calculation guide above.
Most investors consider cap rates between 4% and 10% to be acceptable, though the right number depends on the property type, location, and your risk tolerance. Lower cap rates typically reflect lower-risk properties in high-demand markets. Higher cap rates offer greater income potential but come with more risk. Refer to the benchmark table above for typical ranges by property type.
No. Cap rate measures a property’s income potential independently of how it’s financed, making it useful for comparing properties on equal footing. ROI factors in the full cost of a deal including loan terms, down payment, and improvements, making it more useful for evaluating your personal return on a specific investment.
Not necessarily. A higher cap rate means greater income relative to the property’s value, but it also tends to reflect higher risk. A property with a 9% cap rate in a secondary market may generate more cash flow than one with a 4% cap rate in a major city, but it likely comes with higher vacancy risk, more management intensity, and a smaller pool of future buyers. The best cap rate is one that matches your investment strategy and risk tolerance.
A 7.5% cap rate means the property generates a net operating income equal to 7.5% of its current value each year. For example, a $300,000 property with a 7.5% cap rate produces $22,500 in NOI annually, while a $500,000 property at the same cap rate produces $37,500.
A 6% cap rate means the property generates a net operating income equal to 6% of its current market value per year. On a $400,000 property, that equates to $24,000 in annual NOI. A 6% cap rate is generally considered moderate and is common in established residential markets where properties are stable but competition among buyers keeps prices elevated.
Commercial cap rates vary more than residential ones because they depend heavily on property class, tenant quality, lease terms, and location. As a general benchmark, commercial cap rates typically range from 5% to 12%, with well-leased properties in strong markets sitting at the lower end and higher-vacancy or secondary-market properties at the higher end. For professional benchmarking data by market and asset class, CBRE publishes detailed cap rate research. Comparing properties within the same asset class and region will give you the most meaningful benchmark.
The following operating expenses are included: property taxes, insurance, property management fees, routine maintenance and repairs, utilities where landlord-paid, and legal or accounting fees. Mortgage payments, loan interest, depreciation, and income taxes are excluded. Cap rate is designed to measure property performance independently of financing, so debt-related costs are intentionally left out.
Cap rate is less reliable for fix and flip investments, short-term vacation rentals with seasonal income patterns, and properties with no rental history where income projections are speculative. In these cases, other metrics like ROI or a detailed cash flow analysis will give you a more accurate picture.
