The cap rate is the quickest way to compare income properties: annual profit divided by price. The formula is one line, but the hard part is building the profit figure honestly, because rent alone is not profit.
How it works
Cap rate = net operating income (NOI) / property price x 100. NOI = effective gross income – operating expenses. Effective gross income is scheduled rent minus vacancy losses plus other income such as parking or laundry. Operating expenses include taxes, insurance, maintenance, management, and utilities the owner pays. Loan payments are not an operating expense and stay out of NOI. Capital expenditure treatment varies, so state whether your NOI is before or after reserves.
Step by step
- Add up scheduled annual rent for all units.
- Subtract a vacancy allowance based on local vacancy, not zero.
- Add other recurring income such as parking and laundry.
- Subtract operating expenses: taxes, insurance, maintenance, management, and owner-paid utilities.
- The result is NOI. Divide it by the property price and multiply by 100.
- Compare cap rates only for similar properties in the same market.
Worked example
A building costs $500,000. Scheduled rent is $60,000 per year. Vacancy at 5 percent is $3,000, so effective gross income is $57,000 plus $2,000 other income = $59,000. Operating expenses total $19,000. NOI = $59,000 – $19,000 = $40,000. Cap rate = 40,000 / 500,000 x 100 = 8.0 percent. If expenses were understated by $5,000, NOI would be $45,000 and the cap rate would falsely read 9 percent.
Common mistakes
- Using gross rent instead of NOI, which overstates the cap rate.
- Assuming zero vacancy, which no real building achieves.
- Subtracting mortgage payments from NOI. Debt service is separate.
- Comparing cap rates across different cities as if they meant the same risk.
Try it with the free tool
You can follow every step above by hand, but the free tool below does the same calculation instantly. Try your own numbers in it, then check one result by hand so you trust the method as well as the answer. Open the full tool here: open the tool.
Checklist before you finish
- Write down every input number first, with its unit, before you calculate anything.
- Work through the steps in order, and do not skip the unit conversions.
- Check the answer against the worked example above: is it the right size, and does the direction make sense?
- Round only at the end, and keep the unrounded figure for any follow-up calculation.
Practice with your own numbers
Pick three cases of your own and work each one by hand. First, try a simple round-number case you can check mentally. Second, try a realistic case with awkward numbers, the kind you will actually meet. Third, try an edge case, such as a very small or very large input, and confirm the answer still behaves sensibly. If any case gives a surprising result, re-check the units and the formula step by step before you trust it.
If your answer looks wrong
Most errors come from a small set of causes. Check that you used the same units throughout, that you divided where the formula divides and multiplied where it multiplies, and that you applied any percentage as a decimal. Check the order of operations: powers and brackets come before multiplication and division, which come before addition and subtraction. Finally, test the method on the worked example in this guide. If your method reproduces the example answer, the method is right and the inputs deserve a second look.
Quick tips
A higher cap rate usually means higher risk or lower growth expectations, not automatically a better deal. Always ask for the expense breakdown behind a quoted cap rate before trusting it.