How to Calculate Cap Rate on a Rental Property (With Real Examples)

What Is Cap Rate?

Cap rate, short for capitalization rate, is a metric that measures the relationship between a property's net operating income (NOI) and its current market value or purchase price. It is expressed as a percentage and represents the annual return you would expect to earn on the property if you bought it entirely in cash, without any financing.

The metric is widely used by real estate investors, appraisers, and lenders because it provides a standardized way to compare the income-generating potential of different properties regardless of their size, location, or purchase price. A higher cap rate generally indicates a higher potential return, but it also typically signals higher risk.

The Cap Rate Formula

The formula for cap rate is straightforward:

Net operating income is the property's annual income after subtracting all operating expenses, but before accounting for mortgage payments, income taxes, depreciation, or capital expenditures. Operating expenses include property taxes, insurance, maintenance, property management fees, utilities paid by the owner, and vacancy allowance.

Step-by-Step Example

Consider a duplex in Columbus, Ohio listed for $287,000. The property generates $2,400 per month in rent, or $28,800 annually. Operating expenses for the year include property taxes ($3,200), insurance ($1,800), maintenance ($1,500), property management (8% of rent, or $2,304), and a 5% vacancy allowance ($1,440). Total operating expenses are $10,244.

Net operating income is $28,800 minus $10,244, which equals $18,556. Divide $18,556 by the purchase price of $287,000 and multiply by 100. The cap rate is 6.47%.

What Do the Numbers Mean?

Cap rates vary significantly by market, property type, and asset class. What qualifies as a "good" cap rate in one market might be considered poor in another. Generally, cap rates range from 3% to 12% in most US residential markets, with lower cap rates in high-demand, low-risk markets and higher cap rates in secondary or tertiary markets.

According to the National Association of Realtors, cap rates for multifamily properties averaged 5.2% in 2024, with significant regional variation. The Federal Reserve's commercial real estate data shows that cap rates have compressed over the past decade as interest rates remained low, though this trend shifted in 2022 and 2023 as rates rose.

Cap Rate vs. Cash-on-Cash Return

Cap rate and cash-on-cash return are often confused, but they measure different things. Cap rate is a property-level metric that ignores financing. Cash-on-cash return is an investor-specific metric that accounts for the actual cash invested after financing.

If you buy the Columbus duplex with a 25% down payment ($71,750) and a 30-year mortgage at 7.25%, your annual mortgage payment would be approximately $15,600. Your cash flow after debt service would be $18,556 minus $15,600, or $2,956. Your cash-on-cash return would be $2,956 divided by $71,750, or 4.12%. This is lower than the 6.47% cap rate because financing costs reduce your actual cash return.

Common Mistakes to Avoid

One of the most common errors is using gross income instead of net operating income. Gross income does not account for expenses and will produce an artificially high cap rate that does not reflect reality. Always subtract all operating expenses before calculating cap rate.

Another mistake is excluding vacancy allowance. Even if a property is currently fully occupied, you should account for a typical vacancy rate of 5% to 10% depending on the market. Overestimating occupancy will overstate NOI and produce an inaccurate cap rate.

Finally, avoid comparing cap rates across different property types. A 6% cap rate on a multifamily property in a stable market is not directly comparable to a 6% cap rate on a retail property in a volatile market. Property class, lease terms, and tenant quality all affect what constitutes an appropriate cap rate.

Related Tools on ProfessionCalculators.com

In addition to the Cap Rate Calculator, you may find these tools useful for evaluating rental properties:

• Rental Yield Calculator — Compare rental yield across different markets
• Mortgage Payment Calculator — Estimate monthly payments for different loan scenarios

Frequently Asked Questions

What is a good cap rate for a rental property?

A "good" cap rate depends on your investment strategy and the market. In stable, high-demand markets like San Francisco or New York, cap rates of 4% to 5% are common and may still represent solid investments when factoring in appreciation. In secondary markets like Cleveland or Memphis, investors typically look for cap rates of 8% or higher to compensate for higher risk and lower appreciation potential. Your target cap rate should align with your risk tolerance and investment goals.

Does cap rate include mortgage payments?

No. Cap rate is calculated using net operating income, which is income before debt service. Mortgage payments are not considered in the cap rate calculation. This is intentional — cap rate measures the property's intrinsic income-generating ability, independent of how you choose to finance it. If you want to factor in financing, use cash-on-cash return instead.

How do I calculate net operating income for cap rate?

Start with gross rental income and subtract all operating expenses. Operating expenses include property taxes, insurance, maintenance, property management fees, utilities paid by the owner, and a vacancy allowance. Do not subtract mortgage payments, depreciation, income taxes, or capital expenditures for major repairs. The result is your net operating income, which you then divide by the property value to get the cap rate.

Why are cap rates lower in expensive markets?

Cap rates are lower in expensive markets because high demand drives up property prices faster than rental income can increase. When investors compete for properties in desirable locations, they bid prices up, which compresses the cap rate. The trade-off is that these markets often offer stronger appreciation potential and lower vacancy risk. Investors accept lower current income in exchange for the expectation of long-term value growth and stability.

Should I use purchase price or market value in the cap rate formula?

When evaluating a potential purchase, use the asking price or your intended purchase price. When analyzing a property you already own, use its current market value. Using purchase price for a property you bought years ago will produce an outdated cap rate that does not reflect current market conditions. The purpose of cap rate is to understand current return potential, so the denominator should always reflect current value, not historical cost.

Conclusion

Cap rate is a screening tool, not a final decision. It helps you quickly compare properties and identify which ones warrant deeper analysis. A 7% cap rate in a stable secondary market might be worth pursuing. A 4% cap rate in a volatile high-appreciation market might not pencil out after financing costs. Cap rate alone does not tell you everything: you still need to evaluate property condition, neighborhood trends, tenant quality, and your financing terms.

Our Cap Rate Calculator handles the formula automatically. If you are running the BRRRR strategy on the property, see our BRRRR strategy guide for how cap rate fits into the post-refinance analysis. For tax deferral when you eventually sell, see how 1031 exchanges work.