Real Estate
How To Calculate Cap Rate
The capitalization rate is the return a property would throw off if you owned it outright. Net operating income divided by value, with the mortgage left out of the picture entirely.
Quick Answer
cap rate = net operating income / property value
- NOI
- Net operating income, income minus running costs but before debt
- value
- The current value or purchase price of the property
- vacancy
- The share of rent lost to empty periods and non payment
- opex
- Taxes, insurance, management, repairs and utilities
Annualise the rent, take off vacancy, add any other income, subtract the operating expenses, then divide by the value. A 500000 property with 29100 of net operating income returns 5.82 percent, or its purchase price back in 17.1821 years.
What Is Cap Rate?
The capitalization rate is the annual return a property produces before financing. Divide the net operating income by what the property is worth and you have the number the market uses to compare buildings.
Net operating income is the income after running costs but before debt service. Rent, parking, laundry and fees come in; taxes, insurance, management, maintenance and utilities go out.
Mortgage payments are deliberately excluded. That is what makes the cap rate an unlevered measure, so two identical buildings bought with different loans still compare on equal terms.
Gross yield is the simpler cousin. It divides the gross rent by the value with no expenses taken off, which is why it always looks better: 8.4 percent here against the 5.82 percent the cap rate reports.
Vacancy comes off first. No property is occupied every day of the year, and a five percent allowance is a common planning figure for a stable market.
Other income is easy to overlook. Parking, laundry, storage and pet fees are real income, and on some buildings they move the cap rate by half a point.
Operating expenses are the recurring costs of running the building. Property tax, insurance, management, repairs, landscaping and any utilities the owner pays all belong here.
Capital expenditure usually does not. A new roof or a new boiler is a capital item rather than a running cost, though prudent buyers set money aside for it before deciding what the income is really worth.
A higher cap rate means a higher yield and, usually, a higher risk. Cheaper properties in weaker areas trade at higher cap rates, while prime buildings in strong cities trade lower.
Typical rates sit somewhere between four and ten percent. Class A offices and new apartments in expensive cities are at the low end, and older stock in smaller markets is at the high end.
The cap rate is the reciprocal of the payback period. A cap rate of 5.82 percent means the property pays its own value back in 17.1821 years, before financing and before any growth.
Turn the formula around and it becomes a valuation tool. Divide the net operating income by the cap rate buyers in that market demand, and you have what the property should be worth.
That is why cap rate moves are described as compression or expansion. When investors accept a lower rate for the same income, values rise; when they demand more, values fall.
It is a snapshot, not a forecast. The cap rate says nothing about rent growth, about a lease expiring, or about the roof that needs replacing next year.
Compare it against cash on cash return and internal rate of return, which do include the mortgage, the holding period and the eventual sale.
Formula
cap rate = NOI / property value
Formula page →The unlevered annual return on the value of the property.
| Symbol | Meaning | Unit | Notes |
|---|---|---|---|
| R | Cap rate | decimal | The annual unlevered return, as a decimal. |
| NOI | Net operating income | currency per year | Income after operating expenses, before debt. |
| V | Property value | currency | The current value or price. |
NOI = rent x 12 x (1 - vacancy) + other income - operating expenses
Formula page →Every income line in, every running cost out, nothing about the loan.
| Symbol | Meaning | Unit | Notes |
|---|---|---|---|
| NOI | Net operating income | currency per year | What the property earns before debt. |
| r | Monthly rent | currency per month | The rent collected per month. |
| v | Vacancy rate | decimal | The share of rent never collected. |
| E | Operating expenses | currency per year | The annual cost of running the property. |
value = NOI / target cap rate
Formula page →How buyers and appraisers turn income into a price.
| Symbol | Meaning | Unit | Notes |
|---|---|---|---|
| V | Value | currency | What the property is worth at that rate. |
| NOI | Net operating income | currency per year | The income being capitalised. |
| R_t | Target cap rate | decimal | The return the market demands, as a decimal. |
How To Calculate Cap Rate
- 1
Annualise the rent
3500 a month is 42000 a year. This is the gross scheduled rent before anything is taken off.
- 2
Apply vacancy and add other income
At five percent vacancy the collected rent is 39900, and 1200 of parking and laundry income takes the effective gross income to 41100.
- 3
Subtract the operating expenses
Taxes, insurance, management and repairs come to 12000, leaving 29100 of net operating income. Loan payments are not part of this step.
- 4
Divide by the value
29100 over 500000 is 5.82 percent. The same property shows a gross yield of 8.4 percent and hands back its own value in 17.1821 years.
Examples
Example 1: A 500000 property renting for 3500 a month
- Property value
- 500000
- Monthly rent
- 3500
- Vacancy rate
- 5
- Other monthly income
- 100
- Annual operating expenses
- 12000
| Step | Calculation | Result |
|---|---|---|
| Annual gross rent | 3500 x 12 | 42000 |
| Effective gross income | 42000 x 0.95 + 1200 | 41100 |
| Net operating income | 41100 - 12000 | 29100 |
| Cap rate as a percentage | 29100 / 500000 x 100 | 5.82 |
Result: The property produces 29100 of net operating income on a 500000 value, a cap rate of 5.82 percent. Its gross yield is 8.4 percent and the expenses consume 29.2 percent of the income.
Example 2: A 300000 property renting for 2200 a month
- Property value
- 300000
- Monthly rent
- 2200
- Vacancy rate
- 5
- Other monthly income
- 0
- Annual operating expenses
- 8000
| Step | Calculation | Result |
|---|---|---|
| Annual gross rent | 2200 x 12 | 26400 |
| Effective gross income | 26400 x 0.95 | 25080 |
| Net operating income | 25080 - 8000 | 17080 |
| Cap rate as a percentage | 17080 / 300000 x 100 | 5.6933 |
Result: A cheaper property with proportionally higher running costs produces 17080 of net income on 300000, a cap rate of 5.6933 percent. Expenses take 31.9 percent of income, against 29.2 percent on the larger one.
Calculator
Cap rate
5.82%
- Net operating income
- 29,100
- Effective gross income
- 41,100
- Expenses as a share of income
- 29.20%
- Gross yield
- 8.40%
- Years to recover the value
- 17.1821
Values update as you type. This calculator covers the single scenario its formula assumes — see Common Mistakes for what it leaves out.
Prefer a full-width tool? Open the Cap Rate calculator page.
Common Mistakes
Using gross rent instead of net income
Dividing rent by value gives the gross yield, not the cap rate. Here that reports 8.4 percent instead of 5.82 percent, because the running costs vanish.
Putting the mortgage in the expenses
Debt service is below the cap rate line. Including it turns an unlevered property measure into a personal cash flow figure that cannot be compared between buyers.
Deducting capital expenditure as operating expense
A new roof is a capital item. Mixing it into operating costs makes the year look terrible and the next few years look artificially good.
Assuming zero vacancy
Empty months and non payment are real. Five percent off a 42000 rent is 2100, which moves the cap rate by nearly half a point.
Comparing cap rates across different markets
A five percent cap rate on a new building in a prime city and a nine percent one on older stock elsewhere are not better or worse, they are different risk profiles.
Using the purchase price from years ago
The denominator is current value. A property bought cheaply years ago shows a flattering cap rate on the old price that tells you nothing about today's return.
FAQ
What is the cap rate formula?
Net operating income divided by the property value. Net operating income is the income after vacancy and operating expenses, before any mortgage payment.
What is a good cap rate?
It depends on the market and the risk. Most investment property trades somewhere between four and ten percent, with prime assets at the low end.
How is cap rate different from ROI?
Cap rate ignores financing and looks only at the property. ROI and cash on cash include the mortgage, which is why a leveraged deal can show a return well above the cap rate.
Does the mortgage affect the cap rate?
No. That is the point of the measure. Two buyers with different loans on the same building see the same cap rate and very different cash returns.
How do I value a property from a cap rate?
Divide the net operating income by the rate buyers in that market accept. At 29100 of income and a six percent market rate, the value is about 485000.
What is the difference between cap rate and gross yield?
Gross yield divides rent by value with no costs taken off. The cap rate uses net income, so the gap between them is simply the operating expenses.
References
- [1]Wikipedia, Capitalization rate — https://en.wikipedia.org/wiki/Capitalization_rate
- [2]Wikipedia, Net operating income — https://en.wikipedia.org/wiki/Net_operating_income
- [3]Wikipedia, Real estate — https://en.wikipedia.org/wiki/Real_estate