Cap Rate: The Formula, a Worked Example and What Counts as Good

Cap rate = net operating income ÷ price. A rental that nets $24,000 a year and costs $350,000 has a 6.9% cap rate. It is the return the property would pay if you bought it with cash, before income tax, and it is the fastest honest way to compare one rental with another.

The formula, three ways

The same three numbers, rearranged:

You know	You want	Formula
NOI and price	Cap rate	NOI ÷ price
NOI and a target cap rate	The most to pay	NOI ÷ cap rate
Price and a market cap rate	The NOI it implies	Price × cap rate

The hard part is never the division. It is getting net operating income right. NOI is a year of rent and other income, minus an allowance for vacancy, minus the costs of running the property: property tax, insurance, repairs, utilities the owner pays, management. It does not subtract mortgage payments, depreciation or income tax. Those belong to the owner, not the building.

A worked example, from rent to cap rate

A fourplex is listed at $575,000. Each unit rents for $1,400 a month, and a coin laundry brings in $1,200 a year.

Line	Per year
Gross scheduled rent (4 × $1,400 × 12)	$67,200
Laundry income	$1,200
Vacancy allowance, 5% of rent	−$3,360
Effective gross income	$65,040
Property tax	−$7,800
Insurance	−$3,100
Repairs and maintenance	−$5,400
Management, 8% of income collected	−$5,203
Water, sewer and common electric	−$3,600
Landscaping and snow	−$1,200
Net operating income	$38,737

Cap rate: $38,737 ÷ $575,000 = 6.7%.

You can run the same numbers line by line in the NOI calculator, then take the NOI to the cap rate calculator, which shows the division with your figures in it.

Turn it around: the most you should pay

Buyers often start from the return they want, not the price they are offered. If you want 7.5% on this fourplex:

$38,737 ÷ 0.075 = $516,493

So the asking price is about $58,500 above what a 7.5% buyer would pay. That gap is the negotiation: either the seller comes down, or you accept a lower return, or you find income or savings the current owner has missed. The cap rate calculator in reverse gives the ceiling for any target you type in.

Why a small change moves the price

Because value is NOI divided by the cap rate, small changes in either one move the price a lot. The same $38,737 of NOI is worth $645,617 at a 6% cap rate and $553,386 at 7%: one point of cap rate, about $92,000 of value.

It works on the income side too. Raise each unit’s rent by $25 a month and gross rent grows by $1,200 a year; after the vacancy allowance and the management fee, about $1,050 of it reaches NOI. At the fourplex’s 6.7%, that adds roughly $15,700 to what the building is worth. This is why investors chase small, steady gains in rent and small cuts in expenses: every dollar of yearly NOI is priced many times over when the property sells.

What counts as a good cap rate

There is no single good number, because cap rate prices risk as much as it measures income. Reading it in bands helps:

• Under 4%. Prime locations and newer buildings, where buyers pay up for safety and expected rent growth. The income alone barely covers a loan.
• 4% to 6%. Solid properties in steady markets. Common for well-kept apartments in larger metros.
• 6% to 8%. More income per dollar, often with an older building, a smaller market or more hands-on management.
• Over 8%. Either a real bargain or a real problem. Check the roof, the rent roll and the neighborhood before you believe it.

Two outside numbers keep a cap rate honest. The first is your borrowing cost. If a mortgage costs 6.5% and the property yields 5.5%, every borrowed dollar earns less than it costs, and your cash-on-cash return falls below the cap rate. The second is the yield on long-term Treasury bonds, which carry no rental risk at all. When those yields rise, cap rates tend to follow, and prices fall to make room.

Five ways a cap rate gets inflated

Listings quote cap rates, and sellers want them high. The usual tricks:

1. No vacancy allowance. The NOI assumes every unit is full all year.
2. No management fee. The owner manages it themselves and counts their time as free. A buyer who hires a manager will pay 8% to 10% of rents.
3. Last year’s property tax. In many places the assessment resets after a sale, and the tax bill jumps with it.
4. Pro forma rent. The NOI uses the rent the units “could” get, not what the signed leases say.
5. Deferred repairs. A low repair line looks great until the water heaters and the roof come due.

Here is what the first two do to the fourplex. Drop vacancy and management, and NOI rises from $38,737 to $47,300. The listing now says 8.2% instead of 6.7%, on the same building with the same tenants. Rebuild NOI from the signed leases, the tax bill and a real repair budget, and quote your own number.

Cap rate next to the other yardsticks

Cap rate is one of several quick measures, and each answers a different question:

• Gross rent multiplier: price ÷ gross yearly rent. The fourplex’s GRM is $575,000 ÷ $67,200 = 8.6. Fast, but blind to expenses.
• One percent rule: monthly rent should be at least 1% of price. The fourplex brings in $5,600 a month against $5,750 needed, so it just misses. A filter, not a verdict.
• Cash-on-cash return: yearly cash flow after the mortgage ÷ the cash you put in. It shows what financing does to your return, which cap rate deliberately ignores.

Use GRM and the 1% rule to sort a list of listings. Use cap rate to compare the survivors. Use cash-on-cash to decide how to pay for the one you pick.

The glossary’s cap rate entry has a shorter version of all this, with a sample listing.