The cap rate equation and its three forms
The cap rate equation has three unknowns, so any two give the third.[1]
| Solve for | Formula | Example |
|---|---|---|
| Cap rate | NOI ÷ value | $42,000 ÷ $600,000 = 7.0% |
| Value | NOI ÷ cap rate | $42,000 ÷ 0.07 = $600,000 |
| NOI | Value × cap rate | $600,000 × 0.07 = $42,000 |
Use annual figures on both sides. If you only know monthly rent and costs, multiply by 12 before dividing.
How to calculate cap rate, step by step
- Gross potential income: twelve months of full rent for every unit, plus other income such as parking or laundry.
- Effective gross income: subtract vacancy and credit loss.
- Operating expenses: subtract taxes, insurance, repairs, management, owner-paid utilities and reserves, but not the mortgage, depreciation or income tax.[3]
- NOI: what is left after step 3.
- Divide by value: the price you would pay, or a current appraised value.
Example 1: a single-family rental
A house rents for $2,100 a month. Vacancy is 5%, taxes $3,300, insurance $1,350, maintenance and reserves 10% of rent, management 8% of collected rent. The asking price is $310,000.
| Line | Amount |
|---|---|
| Gross potential income ($2,100 × 12) | $25,200 |
| Less vacancy (5%) | ($1,260) |
| Effective gross income | $23,940 |
| Less operating expenses | ($9,085) |
| NOI | $14,855 |
| Cap rate: NOI ÷ $310,000 | 4.79% |
Example 2: a 12-unit building, two ways
A 12-unit building at $1,450 a unit is offered at $2,350,000. The seller's statement shows 2% vacancy and no management fee or reserves. Rebuilt with the minimums Fannie Mae applies to multifamily underwriting (at least 5% vacancy, management at 3% of income, taxes at last year × 103%, insurance at 105%, reserves of $200 per unit),[3] the picture changes:
| Seller's figures | Lender-style figures | |
|---|---|---|
| Gross potential income | $212,400 | $212,400 |
| Vacancy | ($4,248) | ($10,620) |
| Operating expenses | ($73,200) | ($83,073) |
| NOI | $134,952 | $118,707 |
| Cap rate at the asking price | 5.74% | 5.05% |
Same building, same price, a cap rate about 0.69 points lower once the statement is complete. Always calculate cap rate on an NOI you would defend to a lender.
Example 3: the price that gives a target cap rate
If similar buildings trade at a 6.5% cap rate, the lender-style NOI of $118,707 supports a price of $118,707 ÷ 0.065 = $1,826,255. A market cap rate comes from comparable sales: each comparable's NOI divided by its sale price.[1] The rental property value calculator does this, and also the gross rent multiplier version that appraisal forms use.[4]
Common mistakes when calculating cap rate
- Dividing gross rent by price. That is gross yield, not cap rate; it ignores every expense.
- Subtracting the mortgage. Debt service comes after NOI. With the loan included you are calculating cash-on-cash return on the wrong base.
- Mixing monthly and annual figures. Monthly NOI over an annual price gives a cap rate twelve times too small.
- Using pro forma rents. Projected rents after renovations are not today's income; label the result a pro forma cap rate.
- Using the seller's property tax. In states that reassess on sale, such as California, the buyer's tax can be much higher; see the cap rate California calculator.
- Leaving out management or reserves. Both are real costs even if the current owner does the work.
A cap rate is a price relationship for one year, not a full return.[2] For the meaning behind the number see what is a cap rate, and to calculate yours instantly use the cap rate calculator.
Quick checkIf your cap rate is above the rate on similar recent sales, look for a missing expense before celebrating a bargain.
Frequently asked questions
How do you calculate cap rate?
Subtract vacancy and operating expenses from a year of gross income to get NOI, then divide NOI by the property's price or value. $30,000 ÷ $500,000 = 6%.
How do you figure out the cap rate on a property you are buying?
Ask for the last 12 months of income and expenses, rebuild the NOI with your own vacancy, management and reserve figures and the property tax you will pay after the purchase, then divide by your offer price.
Is cap rate calculated on purchase price or current value?
A buyer uses the purchase price; an owner checking today's position uses current market value. State which one you used when you compare.
Do you use gross or net income for cap rate?
Net operating income: after vacancy and operating expenses, before the mortgage and income tax.
How do I calculate cap rate from monthly rent?
Multiply monthly rent by 12, subtract vacancy and annual operating expenses, then divide by the price.
Sources
- Etter, W. E. Direct Capitalization Versus Discounted Cash Flow Analysis (Publication 1051)
- Etter, W. E. Expected Rate of Return: More than Interest (Publication 1145)
- 203.01 Underwritten Net Cash Flow (Multifamily Selling and Servicing Guide, Part II, Ch. 2)
- Small Residential Income Property Appraisal Report (Form 1025 / Freddie Mac Form 72)