How to Calculate Cap Rate (With Examples)
Step-by-step guide to calculating capitalization rate with real-world examples and common mistakes to avoid.
What Is Cap Rate?
The capitalization rate (cap rate) is the ratio of a property's Net Operating Income (NOI) to its current market value or purchase price. It's the standard metric real estate investors use to evaluate and compare the return potential of investment properties.
Cap rate strips out mortgage payments entirely. This makes it a clean, apples-to-apples tool for comparing properties regardless of how they're financed. A $200,000 duplex in Memphis and a $2,000,000 apartment in Seattle are measured the same way.
Use our free Cap Rate Calculator to run instant calculations as you work through this guide.
The Cap Rate Formula
Cap Rate = Net Operating Income (NOI) ÷ Current Property Value × 100
If a property generates $20,000 in NOI and is worth $300,000:
Cap Rate = $20,000 ÷ $300,000 × 100 = 6.67%
This means for every dollar invested in this property (all-cash), you earn 6.67 cents per year in operating income before taxes and major capital expenditures.
Calculating Net Operating Income (NOI)
NOI is the foundation of cap rate — and where most calculation errors occur. NOI = Effective Gross Income − Operating Expenses.
Step 1: Gross Rental Income
Start with potential gross income at 100% occupancy. For a 6-unit building with units renting at $950/month: 6 × $950 × 12 = $68,400 gross annual income.
Step 2: Subtract Vacancy & Credit Loss
Industry standard is 5–10%. In tight rental markets, 5% is reasonable; in softer markets, use 8–10%.
$68,400 × 5% = $3,420 vacancy. Effective Gross Income = $64,980.
Step 3: Subtract Operating Expenses
Operating expenses include property taxes, insurance, property management (8–12% of collected rent), maintenance (1% of value annually), CapEx reserves, utilities if landlord-paid, landscaping, and professional fees.
What is NOT included in operating expenses: mortgage payments, depreciation, and income taxes. Cap rate is a pre-financing metric.
Step 4: Calculate NOI
For our 6-unit example with $64,980 EGI and $31,000 total expenses: NOI = $64,980 − $31,000 = $33,980. Cap Rate = $33,980 ÷ $450,000 (purchase price) = 7.6%.
What Is a Good Cap Rate?
There is no universal "good" cap rate — context is everything. A 4% cap rate in Manhattan and a 4% cap rate in rural Ohio represent completely different risk/reward propositions.
In general, a higher cap rate means higher income yield but often more risk, lower quality, or a secondary market. A lower cap rate signals lower risk, higher property quality, or a premium location with strong appreciation upside.
The only meaningful benchmark for "good" is: is the cap rate in line with similar properties in the same market? If market cap rates for comparable properties are 7% and you're buying at 9%, you're getting a deal. If market rates are 7% and you're buying at 5%, you're paying a premium — make sure you have a reason why.
Cap Rates by Market and Property Type
By Market Type
Gateway markets (NYC, LA, SF, Miami): 3–4.5% cap rates. Low yield, strong appreciation potential and liquidity. Institutional buyers accept compressed returns for lower risk.
Mid-tier metros (Austin, Denver, Charlotte, Nashville): 5–6.5% cap rates. Balance of cash flow and appreciation. Popular with individual investors.
Secondary markets (Cleveland, Memphis, Kansas City, Birmingham): 7–10%+ cap rates. Strong cash flow, limited appreciation. Favored by out-of-state investors chasing yield.
By Property Type
| Property Type | Typical Cap Rate Range |
|---|---|
| Single-family rental | 5–8% |
| Small multifamily (2–4 units) | 6–9% |
| Apartment building (5+ units) | 5–7% |
| Retail / strip center | 6–8% |
| Industrial | 5–7% |
| Net lease (NNN) | 4–5.5% |
Cap Rate vs. Cash-on-Cash Return
These two metrics are commonly confused. Key difference:
Cap rate ignores financing. It measures the asset's return as if you paid all cash. It belongs to the property.
Cash-on-cash return accounts for your actual financing and measures annual pre-tax cash flow against your actual cash invested (down payment + closing costs). It belongs to the investor, not the property.
Example: Property with 7% cap rate. You buy with 25% down at 7% interest. Your debt service reduces cash flow significantly. Cash-on-cash might be 5–6% (leveraged return lower than cap rate when borrowing costs are high relative to cap rate).
When borrowing costs are lower than the cap rate, leverage boosts cash-on-cash above the cap rate. When borrowing costs exceed the cap rate (negative leverage), cash-on-cash is below cap rate — a warning sign.
Use our Cash Flow Calculator to model leveraged returns alongside cap rate.
Using Cap Rate to Find Property Value
Cap rate works both directions. If you know the NOI and the market cap rate, you can estimate what a property is worth — and what you should pay.
Property Value = NOI ÷ Cap Rate
If comparable properties in a market sell at 7% cap rates and your target property generates $35,000 NOI: $35,000 ÷ 0.07 = $500,000 estimated value. If the seller is asking $575,000, they're implying a 6.1% cap rate — analyze whether the premium is justified.
This is how institutional investors value commercial real estate, and why NOI growth (through rent increases or expense reduction) directly drives property value appreciation.
Common Cap Rate Mistakes
- Using pro forma numbers instead of actual — Verify actual rents, actual vacancy history, and actual expenses from tax returns, not the seller's optimistic projections
- Excluding property management — Include it even if you self-manage. Comparable deals include it; you should too.
- Excluding CapEx reserves — The most common omission on broker pro formas. A roof replacement is a real cost.
- Comparing across different asset classes — A 7% cap on a C-class building in a declining market is not the same risk as 7% on a Class A building in a growing market
- Treating cap rate as the only metric — Cap rate tells you one dimension of return. Combine it with cash-on-cash, DSCR, and equity multiple for a complete picture.
Run the Numbers
Theory is only useful when applied. Take any property you're evaluating and run it through our free Cap Rate Calculator. For a complete picture including financing, also use the Cash Flow Calculator and ROI Calculator.
For more depth on cap rate calculations, see the detailed Cap Rate on Rental Property guide. Related: Complete Rental Property Analysis | Investment Analysis: All Metrics.