What is a Cap Rate and how to calculate it?

Cap rate is short for “capitalization rate.” It’s one of the most fundamental equations when it comes to real estate investing. It can help you build a winning portfolio by showing you the potential return for any given investment that you’re interested in pursuing. This way, possible investors can compare real estate investments to stocks, bonds, ETFs, and more.

You can use the calculator on this page to help you determine the cap rate on a property. And, in this article, we’ll explain to you exactly how -- and why -- cap rates work, including:

  • The definitions of net operating income and current market value -- and how to find them so you can plug them into the formula.
  • An example property to guide you through how to find net operating income, current market value, and, of course, cap rate.
  • An evaluation of the results of the cap rate calculation (what it tells you and what it doesn’t tell you).
  • Understanding how cap rate differs from return on investment (ROI).
  • A final note on optimism (and why it can pay to be a bit pessimistic).

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property cap rate

How Do You Calculate a Cap Rate?

Capitalization Rate = Net Operating Income / Current Market Value

The formula for calculating a property’s cap rate is very simple: NOI (net operating income) divided by the current market value of the asset. If you don’t know how to determine those two numbers, though, (or if you don’t know what they mean) you won’t be able to accurately use cap rates.

And, even worse, if you arrive at an incorrect net operating income or current market value, your cap rate is also going to be incorrect. There’s a popular term in real estate: Garbage in, garbage out. 

So, in order to properly use our calculator and determine the correct cap rate, you need to understand those terms.

Net Operating Income

NOI = Revenue - Operating Expenses

Net operating income refers to all of the income from your property minus the operating expenses (before income taxes, but including property taxes). Net operating income also doesn’t refer to mortgage payments or interest. It’s kind of confusing, but we’ll guide you through it. When net operating income is used for anything other than real estate investment properties, it might help you to know that it’s called “earnings before interest and taxes.”

In terms of research and time, this is probably the most exhausting part of finding the cap rate. You’ll need to find a good amount of specific information about the property you’re interested in purchasing.

Revenue

When you’re looking at a rental property, you might forget that your income isn’t limited to rent alone. There will likely be some income from parking spaces and laundry machines, as well, and maybe some other miscellaneous money-makers. In order to figure out your total income, you need to look at everything that might bring in revenue.

What if the property isn’t built yet and you don’t have hard figures on rent? In this case, you’ll need to do some market research to determine how much income rent should hypothetically bring in. In some cases, you might just be able to find that each unit should rent for, say, $1000/month. If there are 20 units, you’ll have a rough figure of $20k/month in total rental income.

After that, you’ll subtract vacancies from that rent figure, because you’ll need effective rental income (how much you can realistically expect to bring in because in some areas it’s rare to have 100% occupancy).

Operating Expenses

Before you plug that number into the calculator, you need to subtract expenses. That will include:

  • Salaries for any employees
  • Property management
  • Maintenance
  • Utilities
  • Property taxes
  • Insurance
  • Legal fees
  • Vacancies (if you don’t already have hard data on how much revenue is currently generated by rent, so you’re instead assuming 100% occupancy).

After you subtract expenses, you’ll have everything you need to find the second variable in the cap rate formula: Current Market Value.

Current Market Value

Value = How Much The Property is Worth TODAY

Current market value, compared to net operating income, is actually very simple: it refers to how much the property is worth in today’s dollars.

Some people confuse market value with the purchase price, and that’s a problem that will throw off your calculation by a lot. Let’s say, for example, you found an apartment complex that sold for $2.1m three years ago. After calculating total operating expenses, you find that this property might generate as much as a 15% year-over-year return. What a great deal!

The problem is that the property is almost undoubtedly worth more today than it was three years ago. Today it might sell for $2.5-3m -- especially with interest rates at all-time-lows. If you’re looking at a property that was acquired decades ago and you use the purchase price, it’s going to give you a cap rate that looks phenomenal. 

In reality, it could be an average (or below average) investment.

How Do You Find Current Market Value?

Many people will tell you to divide the net operating income of the asset by its cap rate in order to determine market value. Seeing as we’re using current market value to determine cap rate, that creates a little bit of a chicken-egg scenario.

So if you need to find market value, you could either hire a professional appraiser to perform an appraisal on the property, or you could hire a real estate professional to do a comparative market analysis.

Calculating Cap Rate with an Example Property, Step-By-Step

Alright, so let’s say you’re looking at an investment property in a somewhat popular city with about 15 units or so. 

(These are all rough numbers just to give you an idea of how cap rates work, so don’t freak out when you see, for example, that our property management fees are slightly less than 10% of total rental income and say “that could never happen in a big city market in the US!”)

Step 1: Finding NOI

What’s the first step to determining its cap rate? You need to find its NOI, and in order to do that, you need to find out how much revenue the property currently generates. Luckily, there’s plenty of data about rent schedules and vacancies, so you’re able to determine the following about its income:

  • Rental Income: $65,000
  • Laundry: $9,000
  • Parking: $3,000

Total income: $77,000/year

Next, you’ve got all of your expenses:

  • Property management: $5000
  • Insurance: $4500
  • Taxes: $5000
  • Miscellaneous: $1000

Total expenses: $15,500/year

Remember that Net Operating Income is revenue minus expenses, so that brings our Net Operating Income to $61,500.

Step 2: Finding Current Market Value

Next, you need to figure out the value of the property. Luckily, this property sold just two months ago for $1.1m, so you have a solid, recent figure to go off of. Additionally, you found some similar buildings in the same school district with the same number of units, and they all ranged from about $950k to $1.3m, so you can say, with a fair degree of accuracy the current market value of this investment property is $1.1m.

Alternatively, you could hire an appraiser to get a professional appraisal done on the property. That way you can be almost 100% sure how much the property is worth (and, worse comes to worst, at least you can save face by blaming the appraiser).

Step 3: Plug in the Numbers to Find the Cap Rate

Next, just plug the numbers into the formula to find the cap rate.

Cap Rate = NOI / Current Market Value

In this case:

Cap Rate = $61,500 / $1.1m

Cap Rate = 0.0559

Or about 5.6%‍

How to Evaluate the Results of the Cap Rate

Now that we have a theoretical cap rate of 5.6%, you might be wondering, “what does it mean?”

What’s a Good Cap Rate? What’s a Bad Cap Rate?

A good or bad cap rate depends entirely upon what you’re looking for and what you’re comparing the real estate investment too. So, it’s not a great answer, but it depends.

For general purposes, though, a good cap rate is anything north of 4%, and you probably want to aim for at least 5-8% in most markets.

On the flip side, a bad cap rate is probably anything below 4%. For example, if you’re looking at essentially risk-free Treasury bonds, you’re getting 1.25% every year with almost no chance of losing your principal. If your cap rate isn’t at least as high as 1.25%, then, we can assume it’s not a great investment (according to the cap rate).

However, unlike investing in treasury bonds or stocks, you have much more influence over cap rates than most other investments. With good management on a property that was charging below-market rents, you could possibly completely change the cap rate. It’s by no means a static measure.

Also, some people argue that the cap rate isn’t only a measure of profitability but also risk: the lower the cap rate, the safer the investment. And this is true (at least some of the time, sometimes it truly is just a poor investment -- but even that can be offset with a lower tax bill from depreciation).

Before you determine that a property is or isn’t a bad investment because of the cap rate, keep that in mind. Consider, also, the things that the cap rate isn’t telling you.

What Does the Cap Rate Tell You? And What Does It Not Tell You?

You use the cap rate to determine the profitability of a certain investment, to see if it’s worth your money, and likely to have a good return.

However, there are myriad factors that the cap rate doesn’t take into account. The cap rate equation is still a central formula in most real estate investment circles, but it doesn’t paint a full picture.

Think about all of the things that might affect a property value that isn’t taken into consideration, like future rents and vacancies, projected market value, and leverage (which of course includes interest payments). If a big business is relocating in the next couple of years, the apartment building nearby might not be a great investment even if it currently has a 10% cap rate. If you can get a great deal on a $2m property by only putting down 5% and locking in a super-low interest rate, it’s probably going to be a phenomenal investment despite the cap rate.

Cap Rate vs. ROI: What’s the Difference?

How does a cap rate differ from ROI?

As we talked about above, you might want to use ROI and cap rate to determine how well an investment will do. Cap rates only take into account the market value of the asset, not how much money you’re using to secure that asset.

What does that mean exactly? 

Let’s go back to our $1.1m property. It has a theoretical 5.6% cap rate, right? Does that mean its ROI is also 5.6%? Well, if you’re purchasing the property in full, in cash, then yes. On the other hand, if you’re only putting $250,000 down and it opens a cash flow of ~$60k with a solid interest rate, your ROI could be much, much higher. It depends on your other expenses, but in this case, it could be 15%+.

So, in short, the cap rate doesn’t take into account how much money you’re using to secure the property. It ignores mortgage payments, income taxes, and more. ROI, on the other hand, is used to figure out how much money you’re going to get back on your investment. The two metrics are very, very similar -- but they could also be very, very different.

A Note on Optimism: Double-Check Your Numbers

By and large, most people tend to assume that good things are going to happen -- and they don’t like thinking about bad things, so they don’t. As a result, people overestimate how often good things are going to happen and underestimate how often bad things are going to happen. This is a known cognitive bias called optimism bias.

Even when we think we’re being intensely logical by evaluating properties using hard numbers and data, our subconscious might be tricking us into overlooking some key factors. This is especially true if, for example, you’re using total effective rent (rent at 100% occupancy) and assuming you’ll never have any vacancies, but it can show up in a myriad of ways.

When it comes to cap rate, you might be incredibly enthusiastic about making a big purchase. Real estate can get incredibly emotional, and sometimes that can lead to very poor decision-making. The takeaway? Just double-check your numbers and make sure you aren’t tricking yourself into thinking the investment is better than it really is.

Conclusion: Cap Rate

The cap rate formula is a fundamental one in real estate investment. Investors, realtors, landlords, and mortgagors will often use the cap rate as a way of determining the possible return on an investment property.

You can then use that number to compare rental properties with other investment assets, like stocks, bonds, ETFs, and more.

In this article, we took you step-by-step on how to calculate the cap rate on investment property, including how to determine net operating income and current market value.

Net operating income refers to total revenue from the rental property minus total expenses, but it doesn’t include mortgage payments or income taxes -- since those are individual metrics that change from situation to situation, making them better for calculating ROI.

Current market value refers to how much the property is worth in today’s dollars. It isn’t necessarily the same as how much the asset has sold for in the past; that’s price. In order to determine the current market value, you need to compare the investment property to other similar investment properties in the area.

The cap rate has its limitations, too. It doesn’t take into account pretty much any future indicators, like rising (or falling) rent in the area and employment outlooks. Both factors can have an enormous effect on how much you can charge for rent, and on how big of a demand there is for housing.

You can use the calculator on this page to guide you through the process to calculate the cap rate.

You’ll be well on your way to being an expert real estate investor.