The cap rate formula
Cap rate = net operating income ÷ property value (or price)
And turned around: Value = NOI ÷ cap rate. Both forms are useful. The first tells you what yield a price implies, the second what a building is worth if similar buildings trade at a known cap rate. A lower cap rate means a higher price for the same income.
Step 1: from rent to effective gross income
Start with gross potential rent: the rent if every unit were let all year at the current rent. Twelve units at $1,450 a month give $208,800. No building is full all year, and some tenants pay late or not at all, so deduct a vacancy and credit loss allowance, here 5% ($10,440). Add other income such as parking or laundry ($4,800). The result is effective gross income (EGI): $203,160.
Worked example: NOI and cap rate of a 12-unit building
All figures are annual except the monthly rent in B3. The building and its numbers are fictional.
| A | B | Formula in B | |
|---|---|---|---|
| 1 | Maple Court, year 1 | Amount | |
| 2 | Number of units | 12 | |
| 3 | Monthly rent per unit ($) | 1,450.00 | |
| 4 | Gross potential rent | 208,800.00 | =B2*B3*12 |
| 5 | Vacancy & credit loss rate | 5.0% | |
| 6 | − Vacancy & credit loss | 10,440.00 | =B4*B5 |
| 7 | + Other income (parking, laundry) | 4,800.00 | |
| 8 | Effective gross income | 203,160.00 | =B4-B6+B7 |
| 9 | Property tax | 24,000.00 | |
| 10 | Insurance | 7,200.00 | |
| 11 | Repairs & maintenance | 14,400.00 | |
| 12 | Management fee rate (% of EGI) | 8.0% | |
| 13 | Management fee | 16,252.80 | =B8*B12 |
| 14 | Utilities (common areas) | 9,600.00 | |
| 15 | Reserves for replacements | 4,800.00 | |
| 16 | Total operating expenses | 76,252.80 | =B9+B10+B11+B13+B14+B15 |
| 17 | Net operating income (NOI) | 126,907.20 | =B8-B16 |
| 18 | Asking price | 2,150,000 | |
| 19 | Cap rate at asking price | 5.90% | =B17/B18 |
| 20 | Market cap rate, similar buildings | 6.25% | |
| 21 | Value at the market cap rate | 2,030,515 | =B17/B20 |
This guide is educational, not investment advice. Real decisions need local market data, an inspection and professional advice.
Step 2: operating expenses and NOI
Operating expenses are the costs of running the building: property tax, insurance, repairs, management, utilities that the landlord pays, and a reserve for replacing things like roofs and boilers. Here they total $76,252.80, which is 37.5% of EGI. Then:
NOI = EGI − operating expenses = $126,907.20
What is not in operating expenses matters as much. Mortgage payments, interest and principal, are financing costs. Depreciation is an accounting entry, not a cash cost. Income tax depends on the owner. Leaving them out makes NOI the same whoever owns the building and however it is financed, which is exactly what makes cap rates comparable between properties.
Step 3: the cap rate and the value
At the asking price of $2,150,000, the cap rate is $126,907.20 ÷ $2,150,000 = 5.90%. Suppose similar buildings in the area have recently sold at around 6.25%. Then the value the market would put on this income is $126,907.20 ÷ 6.25% = $2,030,515, about $119,485 below the asking price. Either the seller expects something the numbers do not show yet, such as rent increases, or there is room to negotiate.
Small changes in the cap rate move the value a lot. At 6.0% the same NOI is worth $2,115,120, and at 6.5% $1,952,418.
Sanity checks before you trust the NOI
Two quick ratios catch most unrealistic listings. The expense ratio, operating expenses ÷ EGI, is 37.5% here. If a seller's figures show a much lower ratio than similar buildings, expenses are probably missing. The price per unit, $2,150,000 ÷ 12 = $179,167, lets you compare buildings of different sizes with recent sales nearby. Also check that the rent in the model is the rent tenants actually pay today, not a hoped-for market rent, and that the vacancy allowance matches the local market.
What the cap rate does not tell you
The cap rate is a snapshot of one year of stabilized income. It ignores financing, rent growth, future capital spending and the eventual sale. Two buildings with the same cap rate can be very different investments if one needs a new roof next year. Use it to screen and compare deals, then look at cash-on-cash return, the debt service coverage ratio and an IRR over the whole holding period before deciding.
Common mistakes
- Subtracting mortgage payments from NOI. Financing is not an operating expense. Use the debt service coverage ratio to look at the loan.
- Using gross rent without vacancy. A cap rate on 100% occupancy flatters every building.
- Taking the seller's expense figures at face value. Missing management fees or reserves inflate NOI. Rebuild expenses from bills, tax records and quotes.
- Comparing a cap rate on current NOI with one on projected NOI. Make sure every number you compare uses the same basis.
- Treating a high cap rate as a bargain. High cap rates often reflect higher risk: an older building, a weaker location or less reliable tenants.
Frequently asked questions
Does NOI include the mortgage payment?
No. NOI is income minus operating expenses, before any debt service. Mortgage interest and principal are financing costs and are left out so that the result does not depend on how the property is financed.
What is a good cap rate?
There is no universal answer. Cap rates vary with the location, the property type, interest rates and risk. Compare a property with recent sales of similar buildings in the same market.
Is the cap rate the same as the return on investment?
No. It is the unlevered yield in year one. Your actual return also depends on financing, rent growth, capital spending and the sale price, which an IRR over the holding period captures.
How do I calculate value from a cap rate?
Divide the NOI by the market cap rate. A building with NOI of $100,000 in a market where similar buildings trade at 6% is worth about $1.67 million.