How to Figure the Cap Rate for Real Estate

How to Figure the Cap Rate for Real Estate

Learn how to figure the cap rate with our guide. We break down the formula with practical examples to help you analyze real estate deals like a pro.

Domingo Valadez

Nov 12, 2025

Blog

Calculating a property's cap rate is actually pretty simple on the surface. You just divide its Net Operating Income (NOI) by its current market value.

But that one little percentage tells a huge story. It’s a powerful, standardized way to size up a real estate investment's potential return, completely separate from any financing details.

Why Cap Rate Is Your Go-To Metric

Before you ever open a complex spreadsheet or start building out a financial model, you need to get comfortable with one core concept: the capitalization rate. Think of the cap rate as the financial pulse of a property. It's your first-glance indicator of how an asset is performing, and it's a non-negotiable skill for any serious investor.

The real beauty of the cap rate is its simplicity. It cuts through all the noise of financing—like different interest rates, loan terms, and down payments—to show you the raw, unleveraged return of the asset itself. This is what lets you compare an apartment building in Austin to a retail center in Phoenix on a true apples-to-apples basis. Before we get too deep, it's worth getting clear on what exactly is a cap rate in its most fundamental sense.

The Power of a Single Number

The cap rate is like a universal language for real estate investors. When you hear a broker say a property is a “6 cap,” you immediately understand the relationship between its income and its price.

This single number helps you do a few critical things very quickly:

• Compare Opportunities on the Fly: Instantly benchmark different deals against each other to see which one offers a better potential return for the price you’d have to pay.
• Gauge Market Sentiment: You can track whether cap rates in a specific market are compressing (getting lower) or expanding (getting higher). Compressing rates usually signal strong investor demand and rising property values, while expanding rates might suggest the opposite.
• Back-of-the-Napkin Valuation: If you know the typical market cap rate for a certain asset type and you have the property's NOI, you can work backward to get a rough estimate of its value. It's a great gut check.

Understanding the Components

To really get this right, you have to understand what goes into the formula. The inverse relationship here is key: a lower cap rate implies a higher property value for the same amount of income, which often means the market sees it as a less risky investment. That's why the metric is so sensitive to both income projections and how the market perceives risk.

To get started, you only need two key pieces of information.

The formula itself couldn't be simpler:
Cap Rate = Net Operating Income (NOI) / Current Market Value

Let’s quickly break down the inputs you'll need to gather before you can plug them into the formula.

Quick Glance Cap Rate Formula Components

This table gives you a snapshot of the essential inputs for calculating a cap rate, what they mean, and some common examples you'll encounter.

We’ll dig into each of these components in much more detail, but this gives you the basic framework. Getting these two numbers right is the entire game.

Calculating Net Operating Income Accurately

Your Net Operating Income (NOI) is the absolute engine of the cap rate formula. Get this number wrong, and your entire valuation gets thrown off. A small miscalculation here can make a bad deal look good, so getting NOI right is a non-negotiable part of the process.

It all starts with figuring out what a property could earn in a perfect world, and then methodically trimming that down to what it actually earns before you factor in any mortgage payments.

Starting with Gross Potential Income

First, we need a baseline. That’s the Gross Potential Income (GPI), which is the maximum amount of money a property could possibly generate in a year. Think of it as the total income if it were 100% occupied, with every single tenant paying their full rent on time. It's the sticker price for the property's earning power.

To find it, you just add up all the potential income streams.

• Scheduled Gross Rent: The total of all contracted rents from your residential or commercial leases.
• Other Income: Don't forget the other ways a property makes money, like fees for parking, on-site laundry, storage units, or utility reimbursements.

This is your best-case-scenario number. Now, it's time to bring it back down to earth.

Accounting for Vacancy and Credit Loss

Let's be real: no property stays full forever. Tenants move out, it takes time to find new ones, and sometimes, people just don't pay. That's why we have to subtract an allowance for vacancy and credit loss.

One of the biggest rookie mistakes is just taking the seller's pro forma vacancy rate at face value. It's almost always overly optimistic. Do your own homework. Look up the average vacancy for similar buildings in that specific neighborhood. A good local property manager or commercial broker is your best friend here. A 5% vacancy rate is a common plug-in number, but it can easily be higher or lower depending on the market.

Key Takeaway: Never trust a pro forma's vacancy rate without verification. A realistic vacancy and credit loss assumption is one of the most important adjustments you will make to calculate a reliable NOI.

Once you subtract this allowance from your GPI, you get the Effective Gross Income (EGI). This is a far more realistic snapshot of the cash that’s actually going to hit your bank account.

Deducting True Operating Expenses

Now, from that realistic income figure, we need to subtract all the costs required to keep the lights on and the property running smoothly. These are your Operating Expenses (OpEx). Calculating these accurately requires some serious due diligence. This often includes getting a contractor's assessment of a property's potential to spot any lurking deferred maintenance that will hit your budget later.

Your list of operating expenses must include:

• Property Taxes: A big, unavoidable expense.
• Property Insurance: Essential coverage for liability, fire, and other risks.
• Utilities: Any water, sewer, trash, and common area electricity costs that you aren't billing back to tenants.
• Repairs & Maintenance: The day-to-day cost of keeping the property in good shape, from leaky faucets to landscaping.
• Property Management Fees: Usually a percentage of your EGI, often between 4% to 10%.

For a deeper dive into this, our complete guide on how to calculate NOI breaks it down even further with more examples.

This visual shows you exactly how all these pieces fit together.

As the flowchart shows, you take the property’s income, subtract its operating expenses to get the NOI, and then compare that NOI to its value to find the cap rate.

What Not to Include in Operating Expenses

Knowing what to leave out of your OpEx calculation is just as critical as knowing what to put in. I’ve seen many deals go sideways because these next items were mistakenly deducted.

The following costs are NOT operating expenses. They relate to you as the owner and your financing structure, not the property's performance.

• Mortgage Payments (Principal & Interest): This is a debt service cost, not an operating cost.
• Capital Expenditures (CapEx): These are major, one-time upgrades like a new roof or HVAC system. They are considered "below-the-line" expenses.
• Depreciation: An accountant’s tool for tax purposes; it isn’t actual cash leaving your pocket.
• Income Taxes: This depends entirely on the owner's personal financial situation, not the property itself.

Subtract your real, verified Operating Expenses from your Effective Gross Income, and you finally have it: the Net Operating Income. This is the single most important number for calculating a meaningful cap rate. Now you're ready to actually run the numbers.

Putting the Cap Rate Formula to Work

Reading about the cap rate formula is one thing, but running the numbers on a real-world deal is where the rubber really meets the road. Let's break it down with two common scenarios to show you how to apply everything we've covered.

First, we'll look at a straightforward single-family rental. After that, we’ll move on to a slightly more complex small multifamily property, where you have to juggle multiple income streams and a few more expenses.

Single-Family Home Example

Single-family rentals are a great place to start because the math is clean. You've got one source of rent and a fairly predictable set of costs.

Let's imagine you're eyeing a house with a purchase price of $400,000. The seller tells you it currently rents for $2,800 per month.

Here’s how you’d build out the calculation from scratch:

• Gross Potential Income (GPI): The first step is to annualize the rent. At $2,800 a month, that comes out to $33,600 per year.
• Effective Gross Income (EGI): Now, we account for reality. No property stays rented 100% of the time. If the local market vacancy rate is 5%, we need to subtract that potential loss ($1,680) from our GPI. This leaves us with an EGI of $31,920.
• Operating Expenses (OpEx): Next, tally up all the non-debt-related costs to run the property.Property Taxes: $4,500Insurance: $1,200Maintenance & Repairs (5% of EGI): $1,596Property Management (8% of EGI): $2,554Total OpEx comes to $9,850.
• Net Operating Income (NOI): Simply subtract the total operating expenses from the effective gross income.$31,920 (EGI) - $9,850 (OpEx) = $22,070 (NOI)

With our NOI of $22,070, we can finally calculate the cap rate.

Cap Rate = $22,070 / $400,000 = 5.52%

For this house, the resulting cap rate is 5.52%.

Small Multifamily Example

Alright, let's step it up to a four-unit building. Multifamily deals naturally have more moving parts, with different rent rolls and some shared building expenses to consider.

Suppose you're analyzing a fourplex listed for $850,000. Two of the units rent for $1,600/month, and the other two bring in $1,750/month. As a small bonus, the coin-op laundry machine adds about $100 per month.

Let's run the numbers:

• Gross Potential Income (GPI): We need to add up all possible income sources.Units A & B: (2 x $1,600) x 12 = $38,400Units C & D: (2 x $1,750) x 12 = $42,000Laundry Income: $100 x 12 = $1,200This gives us a total GPI of $81,600.
• Effective Gross Income (EGI): For an older building like this, we'll budget for a slightly higher vacancy rate, say 6%. That's a potential loss of $4,896, bringing our EGI down to $76,704.
• Operating Expenses (OpEx): The expense list for a multifamily is usually a bit longer.Property Taxes: $9,500Insurance: $2,800Utilities (owner-paid water/trash): $3,600Repairs & Maintenance: $4,500Property Management (7% of EGI): $5,369Our total operating expenses are $25,769.
• Net Operating Income (NOI): Now we find the bottom line before debt service.$76,704 (EGI) - $25,769 (OpEx) = $50,935 (NOI)

Finally, we divide the NOI by the purchase price to get our cap rate.

Cap Rate = $50,935 / $850,000 = 5.99%

This fourplex is being offered at just under a 6.0% cap rate.

Pro Tip: Don't forget you can flip the formula around for a quick valuation. If you know that comparable fourplexes in the neighborhood are trading at a 5.5% cap rate, you can estimate this property's market value: $50,935 / 0.055 = $926,090. This simple check suggests the $850,000 asking price might be a solid deal, assuming your expense projections are accurate. I use this back-of-the-napkin math constantly to quickly screen opportunities.

Whether you're underwriting a small rental or a major commercial asset, the core process is the same. The real key is being thorough and realistic when you're gathering your income and expense data. This is where a platform like Homebase can be a game-changer. It helps you organize deal documents, model financial projections, and keep all your underwriting in one spot, making it much easier to calculate and compare cap rates across multiple deals.

What a Good Cap Rate Actually Looks Like

https://www.youtube.com/embed/r7kMXHGHEmg

Once you’ve run the numbers and calculated the cap rate, the first question on every investor's mind is always the same: "So... is this any good?"

The honest answer? A cap rate is meaningless in a vacuum. A 5% cap might be a home run for one property but a complete dud for another. It all comes down to context.

There’s no magic number for a "good" cap rate because it's really just a reflection of risk. Think of it as an inverse relationship: the lower the market perceives the risk, the lower the cap rate will be (and the higher the price investors are willing to pay). On the flip side, higher risk demands a higher potential return, which means you'll see a higher cap rate and a lower purchase price.

The Risk and Reward Spectrum

Let's make this real. Imagine a brand-new apartment building in a hot downtown market, filled with tenants on long-term leases. The income stream is about as predictable as it gets. That’s a low-risk bet. Investors will line up for that kind of stability, competing fiercely and driving the price up, which pushes the cap rate down into the 4-5% range.

Now, picture an older, half-empty retail strip in a secondary market with a long list of deferred maintenance. The income is shaky, and turning it around will take a serious injection of cash and effort. This is a much riskier play. To even consider it, an investor needs to be compensated for that risk with a much higher potential return—pushing the cap rate into the 8-10% range, or maybe even higher.

A cap rate is a market-driven consensus on risk and future growth potential. A low cap rate signals that the market believes an asset is safe and has strong prospects, while a high cap rate signals perceived risk or limited growth.

Understanding this fundamental trade-off is far more important than memorizing specific numbers. It helps you read between the lines and understand what the market is telling you about a particular deal.

Finding Your Market's Baseline

So how do you figure out what’s normal for the properties you’re targeting? The key is to find comparable cap rates—or "comps"—for similar properties in your specific submarket. This is how you build a benchmark to measure any new opportunity against.

Here are a few practical ways I find reliable market data:

• Talk to Commercial Brokers: This is your best source, hands down. Brokers who specialize in your asset class and neighborhood live and breathe this data. They know what’s trading and at what price, right now.
• Analyze Market Reports: Big commercial real estate firms like CBRE, JLL, and Cushman & Wakefield publish quarterly reports that often include average cap rates for different property types in major metro areas.
• Use Data Services: Platforms like CoStar and LoopNet are powerful tools for sales comps and cap rate data, though they usually require a paid subscription.
• Network with Other Investors: Don't underestimate the power of your local network. Connecting with other investors and property managers can give you priceless, on-the-ground intel about recent deals.

Gathering this information is what allows you to know if a property listed at a 6% cap rate is a genuine bargain or simply overpriced for its location and condition.

Typical Cap Rate Ranges by Property Type

While local conditions are always the most important factor, it helps to have a general sense of how cap rates differ across the major property types.

Digging into the historical data reveals that while U.S. commercial real estate cap rates certainly move with economic cycles, they've been a remarkably stable metric for investors over the long haul. Between 2001 and 2022, the average cap rate across major property types was about 6.29%. Of course, specific asset classes always show variations based on their unique risk profiles and growth prospects. For a deeper dive into these long-term trends, CBRE has some great research on the connections of commercial property cap rates.

To give you a starting point, here’s a quick look at the typical cap rate ranges you might see in the market today.

Just remember, these are broad guidelines. A Class A office tower in Manhattan will trade at a completely different cap rate than a Class C office building in a suburban market. The real goal isn’t to find one magic number, but to understand exactly where your potential investment fits within the bigger picture.

Avoiding Common Cap Rate Calculation Mistakes

The cap rate formula looks deceptively simple on paper, but I’ve seen firsthand how tiny errors in your assumptions can lead to massive miscalculations. Over years of underwriting deals, I've watched the same critical mistakes trip up investors time and again. Learning to spot and sidestep these pitfalls is what separates a sharp analysis from a costly surprise down the road.

The single biggest error? Blindly trusting the seller's pro forma statement. Let’s be clear: a pro forma is a sales document, not a sworn financial statement. It’s engineered to present the property in the best possible light, often with rosy income projections and suspiciously low expense figures.

Verifying Income and Vacancy Assumptions

Your first job is to put on your skeptic's hat. The seller might project a 2% vacancy rate, but is that realistic for the submarket? A quick call to a local property manager or a review of market reports might reveal the true average is closer to 7%. That 5% difference goes straight to your bottom line and can drastically alter the actual cap rate.

You have to dig into the rent roll and really stress-test the income. Are the current rents at, above, or below market rates? If they're above market, you have to plan for that income to drop when those leases eventually turn over.

Key Insight: The numbers a seller provides are your starting point, not your conclusion. Your due diligence is about replacing their assumptions with your own verified, conservative estimates to build an accurate Net Operating Income.

Correctly Classifying Your Expenses

Another common landmine is miscategorizing expenses. Remember, the NOI calculation only includes operating expenses—the regular, recurring costs of keeping the property running. It absolutely does not include capital expenditures (CapEx).

The distinction is crucial:

• Operating Expense: Patching a small roof leak.
• Capital Expenditure: Replacing the entire roof.

Confusing these two is a critical mistake. Throwing a $50,000 roof replacement into your operating expenses will artificially crush your NOI for that year, giving you a misleadingly low cap rate and a skewed property valuation. Instead, CapEx should be budgeted for separately, often as a "below-the-line" reserve.

Understanding Different Types of Cap Rates

As you get deeper into analysis, you'll realize not all cap rates are created equal. The cap rate you calculate based on the current financials is called the "going-in" or "acquisition" cap rate. Think of it as a snapshot of the property's performance today.

But you also have to think about your "exit" cap rate. This is the cap rate you project the property will sell for at the end of your holding period. A common rookie mistake is assuming the exit cap rate will be the same or lower than your going-in rate. If market conditions change or interest rates rise, cap rates could expand (increase), which would lower your property's future sale price and take a bite out of your total return. Prudent underwriting almost always involves assuming an exit cap rate that is slightly higher than the going-in rate.

Recent trends in U.S. commercial real estate show just how quickly these dynamics can shift. For instance, office real estate cap rates were around 6.54% in late 2023, but forecasts suggest a rise to 7.39% in 2024. This expansion is a direct response to rising investment risk from tighter lending and weaker tenant demand, which has forced a repricing of assets. You can discover more insights about these commercial property cap rate trends on Statista. This really underscores how external economic forces directly influence the cap rates you must use in your analysis.

Comparing Cap Rate with Other Metrics

Finally, while the cap rate is an essential tool for initial screening, it doesn't tell the whole story. It measures the property's unleveraged return, but it completely ignores the powerful effect of financing.

This is where other metrics become crucial for a complete financial picture.

• Cap Rate: Shows the property's raw, unleveraged yield. It's great for comparing different properties on an apples-to-apples basis.
• Cash-on-Cash Return: Measures the annual pre-tax cash flow against the actual cash you invested (your down payment). This shows the return on your money, factoring in your loan.
• Internal Rate of Return (IRR): A more advanced metric that calculates the total return over the entire life of the investment, accounting for the time value of money, loan paydown, and the eventual sale.

A property might have a modest 6% cap rate, but with good financing, your Cash-on-Cash Return could easily be over 10%. Using these metrics together gives you a much richer, more complete understanding of a deal's potential. Avoiding these common mistakes will make your analysis more accurate and your investment decisions far more sound.

Answering Your Lingering Cap Rate Questions

As you start running cap rate calculations on actual deals, a few nuanced questions are bound to pop up. It happens to everyone. Let's tackle some of the most common ones I hear from investors, so you can analyze your next deal with total confidence.

Can I Use the Cap Rate for a Single-Family Home?

Absolutely. While the cap rate is the native tongue of commercial real estate, it’s a fantastic tool for any property that generates income, including single-family rentals. In fact, it's the perfect way to cut through the emotion of buying a house and look at it strictly as a financial asset.

The math is exactly the same. You take the property's annual Net Operating Income and divide it by the purchase price. This gives you a clean, standardized metric to compare that single-family home against a duplex, a small apartment building, or even an entirely different asset class like a dividend-paying stock.

One quick note of caution: with single-family homes, appreciation often plays a much bigger role in the total return equation. The cap rate is a snapshot of the income yield only; it doesn't account for the potential upside from the property's value growing over time.

What Is the Difference Between Cap Rate and ROI?

Getting this distinction right is critical. Think of it like this: the cap rate measures a property's unleveraged annual return. It's calculated as if you paid all cash, intentionally stripping away the effects of financing to judge the property on its own merits.

Return on Investment (ROI), on the other hand, is a much broader concept that almost always accounts for the debt you used. It's a measure of how your money is performing.

For example, a property might trade at a 6% cap rate. But if you secure a great loan, your cash-on-cash return (a specific type of ROI) could easily jump to 10% or higher. The cap rate tells you about the asset's return; ROI tells you about the return on your invested capital.

Here’s a simple way to keep them straight:

• Use the cap rate to compare the fundamental earning power of one property versus another.
• Use ROI metrics (like cash-on-cash return) to analyze how a specific deal structure—your down payment, your loan terms—is performing for you.

How Do I Find a Reliable Market Cap Rate for My Area?

Knowing the going market cap rate is how you spot a good deal. This isn't a number you can just pull out of thin air; you need real-world data. Here are the best places I've found to get it.

• Commercial Real Estate Brokers: Your best bet, hands down. Brokers who specialize in your asset type and neighborhood live and breathe this data. They know what properties are actually selling for right now.
• Public Market Reports: Major brokerage firms like CBRE, JLL, and Cushman & Wakefield publish fantastic quarterly reports. These are great for getting a baseline understanding of average cap rates in major markets.
• Real Estate Data Services: If you're serious, paid platforms like CoStar and LoopNet are the industry standard for granular sales comps and cap rate data.
• Your Local Network: Never, ever underestimate the power of a conversation. Talking to other local investors, appraisers, and property managers can give you on-the-ground intel you simply won't find in a report.

Making your deal analysis more efficient is the key to growing your portfolio. Homebase is an all-in-one platform built to help you manage your deal pipeline, model financials, and create professional investor presentations. Ditch the clunky spreadsheets and start closing more deals—see how it works.

DOMINGO VALADEZ is the co-founder at Homebase and a former product strategy manager at Google.