Calculating cap rate starts with determining the property’s Net Operating Income (NOI) — annual rental income minus operating expenses, but not including mortgage payments, since cap rate is meant to reflect the property’s return independent of how it’s financed. Operating expenses typically include property taxes, insurance, maintenance, property management fees, and a vacancy allowance, but exclude capital expenditures and debt service.
Once you have NOI, divide it by the property’s purchase price (or current market value if you’re evaluating a property you already own) and multiply by 100 to get a percentage. For example: a property generating $60,000 in annual rental income, with $18,000 in total operating expenses, has an NOI of $42,000. If the purchase price is $500,000, the cap rate is $42,000 divided by $500,000, or 8.4%.
A common mistake is using gross rental income instead of NOI, which significantly overstates the return by ignoring real operating costs. Another common error is underestimating vacancy and maintenance reserves — using overly optimistic numbers (assuming zero vacancy, minimal repairs) inflates the calculated cap rate and can lead to a misleading picture of the deal’s actual return.
Cap rate is most useful as a comparison tool across similar properties in similar markets, rather than as a standalone measure of whether a deal is "good." A property’s appropriate cap rate depends on factors like location, tenant quality, lease terms, and property condition, so comparing a property’s cap rate against realistic comparable properties in the same submarket gives a much clearer read than comparing it against a generic national benchmark.