[How to Calculate Cap Rate](/blog/cap-rate-explained): Examples and When It Matters

The capitalization rate (cap rate) is one of the most fundamental metrics in [real estate investing](/blog/brrrr-strategy-guide), yet it's frequently misunderstood and misapplied. Understanding how to calculate and interpret cap rates correctly separates sophisticated investors from amateurs.

This comprehensive guide explains cap rate calculation, provides real-world examples, and teaches you when this metric matters—and when it doesn't.

What Is Cap Rate?

Cap rate measures the annual return on a [real estate investment](/blog/dscr-loan-fix-and-flip) based on the property's [net operating income](/blog/net-operating-income-guide) (NOI) relative to its purchase price or current market value. It's expressed as a percentage and provides a quick snapshot of potential return.

The basic formula:

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

For example, a property generating $50,000 in NOI with a purchase price of $500,000 has a 10% cap rate:

$50,000 ÷ $500,000 × 100 = 10%

The Three Components of Cap Rate

To calculate cap rate accurately, you must understand each component:

1. Net Operating Income (NOI)

NOI is the property's annual income after operating expenses but before debt service and taxes.

NOI Formula:

NOI = Gross Income - Vacancy Loss - Operating Expenses

Gross Income includes:

• Base rent from all units
• Parking fees
• Laundry income
• Storage rentals
• Pet fees
• Any other property-generated revenue

Operating Expenses include:

• Property taxes
• Insurance
• Utilities (if landlord-paid)
• Repairs and maintenance
• [Property management fees](/blog/property-management-fees-guide)
• Landscaping and snow removal
• Pest control
• Common area expenses
• HOA fees (if applicable)
• Administrative costs
• Reserves for replacement

Operating Expenses DO NOT include:

• Mortgage payments ([principal and interest](/blog/amortization-schedule-guide))
• Depreciation
• Income taxes
• Capital improvements
• Leasing commissions (one-time)

2. Property Value

Property value can be:

• Purchase price (for acquisitions)
• Current market value (for portfolio analysis)
• As-is appraised value (for refinancing)

Be consistent with which value you use. Most investors use purchase price when evaluating acquisitions.

3. The Percentage Calculation

Multiply the result by 100 to express as a percentage. Cap rates typically range from 3% to 12%, depending on property type, location, and risk profile.

Step-by-Step Cap Rate Calculation Example

Let's calculate cap rate for a 10-unit apartment building.

Property Details:

• Purchase Price: $1,200,000
• Monthly Rent per Unit: $1,000
• Vacancy Rate: 5%
• Annual Operating Expenses: $48,000

Step 1: Calculate Gross Potential Income

10 units × $1,000/month × 12 months = $120,000

Step 2: Subtract Vacancy Loss

$120,000 × 5% vacancy = $6,000 loss
Effective Gross Income = $120,000 - $6,000 = $114,000

Step 3: Calculate Net Operating Income

NOI = $114,000 - $48,000 = $66,000

Step 4: Calculate Cap Rate

Cap Rate = $66,000 ÷ $1,200,000 × 100 = 5.5%

This property has a 5.5% cap rate.

Real-World Cap Rate Examples

Example 1: Single-Family Rental

Property: 3-bedroom house in suburban market

• Purchase Price: $250,000
• Monthly Rent: $1,800
• Annual Expenses: $4,500 (property tax, insurance, maintenance)

Annual Rent: $1,800 × 12 = $21,600
Vacancy (5%): $21,600 × 0.05 = $1,080
Effective Income: $21,600 - $1,080 = $20,520
NOI: $20,520 - $4,500 = $16,020
Cap Rate: $16,020 ÷ $250,000 × 100 = 6.4%

Example 2: Strip Mall

Property: 8,000 sq ft retail center

• Purchase Price: $1,600,000
• Triple-net lease income: $18/sq ft
• Management & common area: $25,000

Annual Rent: 8,000 × $18 = $144,000
Vacancy: $144,000 × 0.10 = $14,400
Effective Income: $144,000 - $14,400 = $129,600
NOI: $129,600 - $25,000 = $104,600
Cap Rate: $104,600 ÷ $1,600,000 × 100 = 6.5%

Example 3: Large Apartment Complex

Property: 50-unit multifamily building

• Purchase Price: $5,000,000
• Average Rent: $1,200/unit
• Annual Operating Expenses: $280,000

Annual Rent: 50 × $1,200 × 12 = $720,000
Vacancy (7%): $720,000 × 0.07 = $50,400
Effective Income: $720,000 - $50,400 = $669,600
NOI: $669,600 - $280,000 = $389,600
Cap Rate: $389,600 ÷ $5,000,000 × 100 = 7.8%

What's a "Good" Cap Rate?

There's no universal "good" cap rate—it depends on multiple factors:

Property Type Benchmarks (2026)

• Class A Multifamily (urban core): 4-6%
• Class B Multifamily (suburban): 5-7%
• Class C Multifamily (value-add): 7-10%
• Single-Family Rentals: 5-8%
• Retail (anchored): 6-8%
• Retail (unanchored): 7-10%
• Office (CBD): 5-7%
• Office (suburban): 7-9%
• Industrial/Warehouse: 5-7%
• Self-storage: 6-9%

Risk-Return Relationship

Lower cap rates (4-6%) indicate:

• Stable, established markets
• High-quality properties
• Strong tenant bases
• Lower perceived risk
• Higher prices (premium)

Higher cap rates (8-12%) indicate:

• Emerging or declining markets
• Higher risk properties
• Deferred maintenance
• Management challenges
• Value-add opportunities

When Cap Rate Matters

Cap rate is most useful in these scenarios:

1. Comparing Similar Properties

Cap rate excels at comparing properties of similar type in the same market:

• Property A: 6.5% cap rate, $800,000
• Property B: 7.2% cap rate, $750,000
• Property C: 5.8% cap rate, $900,000

Property B offers the highest return relative to price, but investigate why—is it riskier, or just underpriced?

2. Market Analysis

Cap rates reveal market trends:

• Declining cap rates: Prices rising faster than income (investor demand, appreciation)
• Rising cap rates: Prices falling or income declining (weakening market, risk increase)

3. Quick Valuation Estimates

Use prevailing market cap rates to estimate property value:

Property Value = NOI ÷ Cap Rate

If comparable properties sell at 7% cap rates and your property generates $70,000 NOI:

Value = $70,000 ÷ 0.07 = $1,000,000

4. Portfolio Performance Tracking

Track cap rates across your portfolio to identify underperforming assets or rebalancing opportunities.

When Cap Rate DOESN'T Matter

Cap rate has significant limitations:

1. Properties with Different Holding Periods

Cap rate measures one year's return. It ignores:

• Appreciation potential
• Loan amortization
• Tax benefits
• Exit strategy

A 5% cap rate property in a high-growth market may outperform a 9% cap rate property in a declining market over 5-10 years.

2. Development or Value-Add Projects

Current cap rate on underperforming properties is meaningless. Focus on stabilized cap rate after improvements:

• Current NOI: $40,000 (10% cap on $400,000)
• After renovation NOI: $75,000 (9% cap on $833,000)

The value-add strategy creates $433,000 in value—current cap rate misses this.

3. Financed Purchases

Cap rate ignores financing. Cash-on-cash return (COC) matters more when using leverage:

Property: $1,000,000 at 7% cap

• 100% cash: 7% return on $1,000,000
• 75% LTV at 5% interest: 13%+ COC on $250,000 down payment

4. Different Property Types

Never compare cap rates across property types:

• Single-family rental: 6% cap
• Retail center: 8% cap

The retail property isn't "better"—different risk profiles, management intensity, and tenant stability make direct comparison meaningless.

5. Markets with Different Risk Profiles

A 10% cap in Detroit isn't comparable to a 10% cap in Austin—market dynamics, appreciation potential, and risk levels differ dramatically.

Common Cap Rate Mistakes

Mistake #1: Including Mortgage Payments in Expenses

Wrong:

Gross Income: $100,000
Expenses + Mortgage: $80,000
"NOI": $20,000

Mortgage payments are not operating expenses. NOI must exclude all financing costs.

Mistake #2: Ignoring Vacancy

Wrong:

10 units × $1,000 × 12 = $120,000 income

Even well-managed properties experience turnover. Use realistic vacancy rates (5-10% for residential, 10-15% for retail).

Mistake #3: Using Gross Income Instead of NOI

Wrong:

Cap Rate = Gross Income ÷ Price

This is [Gross Rent Multiplier](/blog/gross-rent-multiplier-guide) (GRM), not cap rate. Always use NOI.

Mistake #4: Forgetting Reserves

Operating expenses must include reserves for:

• Roof replacement
• HVAC systems
• Parking lot resurfacing
• Major appliances

Typical reserve: $200-$400 per unit annually.

Mistake #5: Comparing Apples to Oranges

Don't compare:

• Properties in different markets
• Different property types
• Different asset classes
• Pro forma vs. actual NOI

Pro Forma vs. Actual Cap Rate

Sellers often advertise pro forma cap rates based on optimistic projections:

• Higher rents than market rates
• Lower vacancy than realistic
• Understated expenses
• Anticipated but unproven income

Always calculate actual cap rate using:

• Current in-place rents
• Realistic vacancy based on history
• Fully-loaded operating expenses
• Conservative income assumptions

The difference between pro forma and actual cap rate reveals seller optimism or manipulation.

Advanced Cap Rate Analysis

Terminal Cap Rate

In multi-year projections, the terminal cap rate estimates exit value:

Year 5 NOI: $100,000
Terminal Cap Rate: 7%
Exit Value: $100,000 ÷ 0.07 = $1,428,571

Terminal cap rates are typically 0.5-1.5% higher than going-in cap rates (assuming some market deterioration).

Cap Rate Spread

The spread between cap rate and mortgage interest rate indicates leverage benefit:

• Cap Rate: 7%
• Mortgage Rate: 5%
• Positive Spread: 2%

Positive spread means leverage enhances returns. Negative spread (cap rate < mortgage rate) means leverage reduces returns.

Reversionary Cap Rate

For properties with above or below-market leases, calculate the reversionary cap rate when leases roll to market:

• Current (below-market) NOI: $80,000
• Current cap: 6.4% ($80,000 ÷ $1,250,000)
• Market NOI: $100,000
• Reversionary cap: 8% ($100,000 ÷ $1,250,000)

Cap Rate and Your Investment Strategy

Match cap rate expectations to your strategy:

Core (Stable Income): 4-6% cap

• Institutional-quality assets
• Strong markets
• Minimal management
• Low risk, low return

Core-Plus (Income + Upside): 5-7% cap

• Good markets
• Minor improvements needed
• Moderate risk/return

Value-Add: 7-10% cap

• Underperforming assets
• Renovation opportunities
• Active management
• Higher risk/return

Opportunistic: 10%+ cap

• Significant challenges
• Heavy value-add or development
• Highest risk/return

Frequently Asked Questions

What's the difference between cap rate and ROI?

Cap rate measures one year's NOI return on property value, ignoring financing. ROI (Return on Investment) includes all income sources (rent, appreciation, tax benefits) and accounts for your actual cash invested. Cap rate = property performance; ROI = investor performance. A 6% cap rate property might deliver 15% ROI with leverage and appreciation.

Why do cap rates vary by location?

Cap rates reflect perceived risk and return expectations. Low cap rates in San Francisco (4-5%) indicate investors accept lower current income for appreciation potential and stability. High cap rates in declining markets (9-12%) compensate for higher risk, management intensity, and limited appreciation. Location drives risk perception, which drives cap rate.

Can cap rate be negative?

Theoretically yes if a property has negative NOI (expenses exceed income). In practice, this indicates a failed investment that should be sold or repositioned. Properties rarely trade with negative NOI—sellers either fix operations or price reflects massive value-add opportunity.

How does cap rate relate to property value?

Cap rate and value are inversely related. When cap rates decrease, property values increase (and vice versa). If NOI stays constant at $100,000: 8% cap = $1,250,000 value; 6% cap = $1,666,667 value. Rising property values compress cap rates; falling values expand cap rates.

What cap rate should I use for my analysis?

Use market-derived cap rates from recent comparable sales in your submarket for similar property types. Survey 5-10 recent transactions and calculate their cap rates. Apply the median cap rate to your property's NOI for valuation. Avoid using arbitrary cap rates not supported by market data.

How do interest rates affect cap rates?

Rising interest rates typically increase cap rates (decrease values) because: (1) higher borrowing costs reduce investor returns, requiring higher cap rates to compensate, and (2) alternative investments (bonds) become more attractive, reducing real estate demand. Generally, cap rates move 40-60% in the same direction as Treasury rates.

Should I buy a property with a low cap rate?

Low cap rates aren't inherently bad—they reflect lower risk and potential appreciation. Buy low-cap properties (4-6%) if: (1) you prioritize stability over current income, (2) the market has strong appreciation potential, (3) you can add value through management/improvements, or (4) you're building long-term wealth. Low cap rates are concerning only if you're overpaying without compensating factors.

What's a cap rate compression and why does it matter?

Cap rate compression occurs when cap rates decrease (values increase) for properties with stable NOI. This happens in improving markets with strong investor demand. It matters because you profit from compression at sale: buy at 8% cap, sell at 6% cap = 33% value increase with zero NOI growth. Conversely, cap rate expansion destroys value even if NOI improves.

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Cap rate is a powerful tool for real estate investors, but only when calculated correctly and applied appropriately. Master NOI calculation, understand market context, and recognize cap rate's limitations. Use it as one metric in comprehensive analysis that includes cash-on-cash return, IRR, equity multiple, and qualitative factors. The best investors use cap rate to quickly assess opportunities, then dig deeper with complete financial modeling before making decisions.

Related Articles

• Property Taxes Explained: How They Work and How to Reduce Them
• [[Bonus Depreciation](/blog/depreciation-rental-property-guide) for Real Estate in 2026: What's Changed](/blog/bonus-depreciation-real-estate-2026)
• Cap Rate Explained: The Complete Beginner's Guide to Capitalization Rate