How to Calculate Cap Rate on Rental Property

What Is Cap Rate?

The capitalization rate—almost always called the 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 quickly compare the return potential of different properties without financing in the picture.

Cap rate strips out mortgage payments entirely. This makes it a clean, apples-to-apples comparison tool across properties, markets, and asset classes. A $200,000 duplex in Cleveland and a $2,000,000 apartment building in Nashville both get measured the same way.

Use our free Cap Rate Calculator to run instant calculations as you read through this guide.

The Cap Rate Formula

The formula is straightforward:

Cap Rate = Net Operating Income (NOI) ÷ Current Property Value × 100

For example, if a property generates $18,000 per year in NOI and you're purchasing it for $250,000:

Cap Rate = $18,000 ÷ $250,000 × 100 = 7.2%

That 7.2% means for every dollar you invest in this property (assuming an all-cash purchase), you earn 7.2 cents per year before taxes and major capital expenditures.

Calculating Net Operating Income (NOI)

The cap rate formula is only as good as your NOI calculation. Most beginners overestimate NOI—and end up overpaying for properties as a result.

Step 1: Gross Rental Income

Start with your potential gross income—what the property would earn at 100% occupancy. For a 4-unit building with each unit renting at $900/month:

4 × $900 × 12 = $43,200 gross annual income

Step 2: Subtract Vacancy & Credit Loss

No property stays 100% occupied. Industry standard is 5–10% vacancy depending on market conditions. Use local data if you have it. In a tight rental market like 2024, 5% is reasonable; in a softer market, use 8–10%.

$43,200 × 5% vacancy = $2,160 vacancy loss
Effective Gross Income = $41,040

Step 3: Subtract Operating Expenses

This is where most investors get burned. Operating expenses typically include:

• Property taxes — check the county assessor's website for exact figures
• Insurance — landlord policies typically run $800–$2,000/year for residential rentals
• Property management — typically 8–12% of collected rent
• Maintenance & repairs — budget 1% of property value per year for older homes, 0.5% for newer
• Utilities (if landlord-paid) — water, trash, common area electric
• Landscaping & snow removal
• Reserves for capital expenditures — roofs, HVAC, water heaters
• Accounting and legal fees

What does NOT count as an operating expense: mortgage payments, depreciation, or income taxes. Cap rate is a pre-financing metric.

Continuing our example:

• Property taxes: $4,200
• Insurance: $1,400
• Property management (10%): $4,104
• Maintenance (1% of value): $2,500
• CapEx reserves: $2,000
• Utilities: $600

Total Operating Expenses = $14,804

Final NOI Calculation

NOI = $41,040 − $14,804 = $26,236

With a $250,000 purchase price: Cap Rate = $26,236 ÷ $250,000 × 100 = 10.5%

What Is a Good Cap Rate?

The answer depends almost entirely on the market and property type. There's no universal "good" cap rate—context is everything.

Cap Rates by Market Type

Gateway markets (NYC, LA, SF, Miami): 3–4.5% cap rates. Low yield but high appreciation potential and liquidity. Institutional buyers accept compressed returns for lower risk.

Mid-tier markets (Austin, Denver, Charlotte, Nashville): 5–6.5% cap rates. Balance of cash flow and appreciation. Popular with individual investors for good reason.

Secondary markets (Cleveland, Memphis, Kansas City, Detroit): 7–10%+ cap rates. Strong cash flow, limited appreciation. Often favored by out-of-state investors chasing yield.

Cap Rates by Property Type

Single-family rentals typically show cap rates of 5–8%. Small multifamily (2–4 units) runs 6–9%. Larger apartment buildings (5+ units) tend toward 5–7% in most markets. Commercial properties vary widely: retail and industrial often command 6–8%, while net-leased properties can dip to 4–5%.

Cap Rate vs. Cash-on-Cash Return

These two metrics are frequently confused. Here's the key difference:

Cap rate ignores financing. It tells you the asset's return as if you paid cash.

Cash-on-cash return accounts for your actual financing. It measures your annual pre-tax cash flow against your actual cash invested (down payment + closing costs).

Example: That same property with 20% down ($50,000) and a $200,000 mortgage at 7% (30-year) has annual debt service of ~$15,978. Your actual annual cash flow: $26,236 NOI − $15,978 debt service = $10,258. Cash-on-cash = $10,258 ÷ $50,000 = 20.5%.

Leverage dramatically changed the return picture. Use our Cash Flow Calculator to model leveraged returns.

5 Common Cap Rate Mistakes

1. Using "Pro Forma" Numbers Instead of Actual

Sellers present pro forma (projected) income and expenses that often paint an unrealistically rosy picture. Always verify actual rents, actual vacancy rates, and actual expense history from tax returns and bank statements. Current rents are what matter—not what units "could" rent for after renovation.

2. Ignoring Property Management

Even if you plan to self-manage, include property management as an expense. If you ever get sick, move, or simply want your weekends back, you'll need a PM. Including this expense also makes your analysis comparable to other deals.

3. Underestimating Capital Expenditures

CapEx reserves are the most commonly skipped expense. A new roof on a 2,000 sq ft home runs $8,000–$15,000. An HVAC replacement is $3,000–$7,000. Water heaters, appliances, exterior painting—it adds up fast. Set aside at least $100–$150/unit/month for CapEx on older properties.

4. Applying the Wrong Purchase Price

Cap rate uses purchase price OR market value—not your financed amount. If you negotiate $230,000 on a $250,000 asking price, use $230,000. This changes your cap rate from 10.5% to 11.4% in our example—a meaningful difference.

5. Comparing Across Different Asset Classes

A 7% cap rate on a C-class apartment building in a declining neighborhood is not equivalent to a 7% cap rate on a Class A multifamily in a growing suburb. Risk is not priced into cap rate. Always layer in your qualitative analysis: neighborhood trajectory, tenant quality, property age, and deferred maintenance.

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 the property is worth—and what you should pay for it.

Property Value = NOI ÷ Cap Rate

If similar properties in a market sell at a 7% cap rate and your target property generates $28,000 NOI:

$28,000 ÷ 0.07 = $400,000 estimated value

This is how institutional investors value commercial real estate. If the seller is asking $450,000, they're pricing it at a 6.2% cap—you'd need to believe NOI will grow or that the market will compress further to justify paying that premium.

Run the Numbers Now

Theory is only useful when applied. Take any property you're evaluating right now and run it through our free Cap Rate Calculator. It handles all the math and shows you how your deal stacks up against market benchmarks.

For a more complete picture of any rental property, also run the numbers in the Cash Flow Calculator to see actual post-financing returns, and the ROI Calculator for total return including appreciation.

Want to compare software platforms that can help you track these metrics across a portfolio? Check the Real Estate Software Directory for property management and analysis tools. For more foundational investing knowledge, read our Complete Guide to Analyzing Rental Properties.