How to Calculate Cap Rate on Rental Property: Simple Guide

How to calculate cap rate on a rental property (without fooling yourself)

Two identical duplexes, same street, same rent roll. One sells for $340,000, the other for $410,000. Same building, same tenants, same mailbox. The difference is the cap rate the buyers agreed on — and the fact that both of them believe they got a deal.

That's the strange thing about this number. It looks objective. Four inputs, one division, done. In practice, the cap rate is the most negotiated figure in real estate, because almost everything that matters hides in how you build the numerator.

I've watched investors take a seller's stated cap rate at face value, sign, and discover eighteen months later that the real figure was closer to 4% than the 7% they were promised. Not fraud. Just a different set of assumptions about vacancy, maintenance, and what counts as an operating expense.

So let's build it properly. Slowly, with the parts nobody puts on the flyer.

The cap rate formula, and the one input everyone gets wrong

Cap rate is net operating income divided by the property's price or current market value.

Cap Rate = NOI ÷ Price

Two numbers. That's the whole thing. The trouble is that the second one is easy and the first one is a minefield.

What is the formula for calculating the cap rate of a property based on its net operating income (NOI)?

NOI is your gross rental income minus all operating expenses — and only operating expenses. Here's the structure:

• Gross scheduled income (what you'd collect at 100% occupancy, all year)
• Minus vacancy and credit loss (the units that sit empty, the tenant who stops paying)
• Equals effective gross income
• Minus operating expenses: property taxes, insurance, property management, repairs, maintenance, utilities you cover, HOA dues, landscaping, pest control, advertising for vacancies
• Minus a capital reserve for big-ticket items (roof, HVAC, flooring)
• Equals NOI

What does not appear: your mortgage payment, your interest, your principal, your depreciation, your income taxes. This is deliberate. The cap rate is designed to describe the property as a standalone asset, independent of how it's financed. A cash buyer and a leveraged buyer should compute the same NOI for the same building.

Where people go wrong is the reserve line. I used to leave it out. On my third property — a 1970s fourplex with original galvanized plumbing — I budgeted $80/month for maintenance and felt generous. Two years later a supply line failed in unit 3 and I wrote a check for $2,900. That single event ate roughly three years of my reserve. I now pencil in 8-10% of gross rent for repairs and capital reserves on anything older than thirty years, and closer to 5% on newer builds.

That's not a rule you'll find printed anywhere official. It's what the numbers on my own spreadsheet forced me to accept.

The vacancy line: the expense nobody wants to include

Every seller's pro forma shows 100% occupancy. Every seller's actual building has had a turnover in the last eighteen months. These two facts coexist comfortably on the same page.

Vacancy and credit loss is not pessimism. It's arithmetic. Between tenant turnover, repainting, cleaning, and the two to six weeks a unit typically sits empty between leases, most residential rentals lose somewhere between 5% and 10% of gross rent annually. In softer markets, or with older stock, it climbs higher. Short-term rentals lose far more — a property booked 65% of the year is running a 35% vacancy rate, which is normal and fine, but it has to show up in the math.

Credit loss is the uglier cousin. One tenant who stops paying, followed by a two-month eviction process in many jurisdictions, can wipe out the entire year's projected margin on a single unit.

Can you provide an example of a cap rate?

Let's run a real one. Duplex, purchased for $320,000. Each side rents for $1,450/month.

Line item	Annual amount
Gross scheduled income (2 × $1,450 × 12)	$34,800
Vacancy and credit loss (7%)	−$2,436
Effective gross income	$32,364
Property taxes	−$3,900
Insurance	−$2,100
Property management (8% of EGI)	−$2,589
Repairs and maintenance	−$2,400
Water and sewer (owner-paid)	−$1,300
Landscaping and snow removal	−$900
Capital reserve (7% of gross)	−$2,436
Net operating income	$16,739

Cap rate: $16,739 ÷ $320,000 = 5.2%.

Now look at what the listing probably said. If the seller had used gross rent minus taxes and insurance only — no vacancy, no management, no reserve — the "NOI" would be around $28,800, and the advertised cap rate would be 9%. That's a 3.8-point gap. Same building. Same street. Two completely different stories about what you're buying.

This is why I stopped reading cap rates on listings. I rebuild them from scratch, every time.

Is cap rate the same as ROI?

No, and confusing them is one of the most expensive mistakes in rental investing.

Cap rate describes the property's unleveraged performance. It answers: if I paid all cash for this building, what return would the operations produce?

ROI describes your return on the money you actually put in. It includes the mortgage. It includes your down payment. It includes principal paydown, cash flow after debt service, and appreciation when you sell.

Here's the divergence in practice. Take that duplex. All-cash, your return is roughly 5.2% before appreciation. Now put 25% down — $80,000 — and finance $240,000 at 6.75% over 30 years. Your annual debt service lands around $18,700.

Your NOI is $16,739. Your debt service is $18,700. You are negative $1,961 per year before principal paydown, on a property with a perfectly respectable 5.2% cap rate.

That's the answer nobody gives you. A good cap rate and a negative cash-flow property can be the same building. The cap rate told you the truth about the asset. It said nothing about your mortgage.

In a market where borrowing costs sit where they do now, the spread between cap rate and mortgage rate is the single number I check first. When the cap rate is below your loan rate, you're funding the difference out of pocket every month and betting on appreciation to bail you out. Sometimes that bet pays. It's still a bet.

What is the 1% rule in real estate?

The 1% rule is a quick screen, not a calculation. It says monthly gross rent should equal at least 1% of the purchase price. A $250,000 property should rent for $2,500/month to pass.

It exists because it's fast and requires no spreadsheet. In markets where it holds, the property usually cash-flows after expenses. In markets where it doesn't — most coastal metros, most of the Sun Belt after the last decade of price growth — it fails almost everywhere, and investors ignore it entirely and buy for appreciation instead.

I used it as a first filter for years. It's useful. It is not a substitute for a cap rate, because it says nothing about taxes, insurance, management, or the age of the roof. Two properties can both pass the 1% rule, and one of them is a money pit with a 1960s electrical panel.

Going-in cap rate vs exit cap rate

These two terms appear in every commercial offering memorandum and almost never get explained.

Going-in cap rate is what you calculate today: current NOI divided by purchase price. It's your entry yield.

Exit cap rate is your assumption about the cap rate at the moment you sell. If you buy at a 5.2% going-in cap and plan to sell in seven years, you have to assume something — 5.2%? 6%? 4.5%?

This matters more than most buyers realize, because property value is derived from NOI and cap rate: Value = NOI ÷ Cap Rate. If your NOI grows from $16,739 to $22,000 over seven years, but exit cap rates have expanded from 5.2% to 6.5%, your sale price is $338,000 — barely above what you paid, despite a 31% increase in income.

The conservative habit I've adopted: assume your exit cap rate is 50 to 75 basis points higher than your going-in rate. If the deal still works on those terms, it works. If it only works because you assumed cap rate compression, you're not underwriting — you're hoping.

What is a good cap rate for a rental property?

There's no universal answer, and anyone who gives you one is selling something.

What's true is that cap rates cluster by asset type and market, because they reflect risk. Stable, well-located residential property in a supply-constrained metro trades at lower cap rates — often in the 4-5% range these days — because buyers are confident about rent growth and resale. Older Class C stock in secondary markets might trade at 8-10%, and the higher number is not a bargain. It's compensation for risk you will actually experience: turnover, deferred maintenance, weaker tenants, slower rent growth.

Comparisons worth keeping in mind:

• Single-family rental: typically the lowest cap rates, strongest appreciation history, thinnest cash flow
• Small multifamily (2-4 units): the middle ground most individual investors land in
• Larger apartment buildings: cap rates set by institutional buyers, sensitive to interest rates
• Commercial retail and office: wider ranges, and office specifically has been repriced hard in recent years for reasons everyone understands
• Short-term rentals: gross yields look spectacular and net yields often don't, once you subtract management, cleaning, platform fees, utilities, and that 35% vacancy

My working rule: a cap rate is "good" if it exceeds your cost of capital by enough to compensate you for the hours you'll spend managing the thing. If your mortgage rate is 6.5% and the cap rate is 5.2%, you're paying for the privilege. That can be rational — appreciation, tax treatment, principal paydown — but call it what it is.

Where the calculation goes wrong

Three failure modes show up again and again.

Using seller numbers. Pro formas are marketing documents. Rebuild the NOI from the lease agreements, the actual tax bill, and a real insurance quote. I've never once found a seller's stated NOI to be too low.

Ignoring deferred maintenance. A cap rate calculated on a building with a 22-year-old roof is not the cap rate you'll experience. The roof is coming. Either price it in or expect the hit.

Applying residential cap rates to commercial property. These are different markets with different buyers, different lease structures, and different risk profiles. A 6% cap rate on a strip mall and a 6% cap rate on a duplex are not the same investment, and treating them as equivalent will cost you.

One more: don't compute a cap rate on a property you already own using your original purchase price and current NOI, then compare it to market cap rates. That's not a cap rate. That's a yield on cost, and it's a different (useful) metric.

The number that actually matters

Run the duplex again. 5.2% cap rate, negative $1,961 in annual cash flow after debt service, and — depending on your market — somewhere between 2% and 4% annual appreciation on a $320,000 asset.

Is that a good deal? I genuinely don't know, and neither does anyone who hasn't seen your tax bracket, your financing terms, and your tolerance for a late-night call about a broken water heater.

What I do know is this: the cap rate is a comparison tool, not a verdict. It lets you line up ten properties and see which ones are priced for the income they produce. Everything after that — leverage, appreciation, your own patience — is a separate conversation. The investors I've watched do well over the long run are the ones who compute the number honestly, then decide with their eyes open about what it doesn't capture. The ones who struggle are the ones who liked the number on the flyer.

Build it yourself. Every time.