What a cap rate measures
The capitalization rate, or cap rate, is a property’s yearly net operating income (NOI) divided by its price or value. It tells you how much income the building produces per dollar of price if you bought it with cash. Because it ignores the loan, you can use it to compare buildings side by side no matter how each buyer pays.
The same formula works three ways, which is what the calculator’s modes do:
- Cap rate = NOI ÷ price
- Value = NOI ÷ cap rate
- NOI needed = price × cap rate
How to build NOI
Start with the rent the property would bring in at full occupancy, plus other income such as laundry or parking. Subtract an allowance for vacancy and unpaid rent to get effective gross income. Then subtract operating expenses: the costs of running the building each year. The IRS list of common rental expenses in Publication 527 is a good checklist: advertising, cleaning and maintenance, insurance, legal and professional fees, management fees, repairs, taxes and utilities.
Leave these out of NOI:
- Mortgage principal and interest. Debt service depends on the buyer, not the building.
- Depreciation. It is a tax deduction, not a cash cost. Pub 527 generally spreads residential rental buildings over 27.5 years.
- Income taxes. They depend on the owner.
- Capital improvements. The IRS treats work that betters, restores or adapts the property (a new roof, a furnace, a kitchen remodel) as an improvement you capitalize, not a repair. Many investors set aside a separate yearly reserve for these instead.
Worked example
A small building rents for $4,500 a month in total and is listed at $600,000.
| Line | Amount / year |
|---|---|
| Gross potential rent ($4,500 × 12) | $54,000 |
| Vacancy and credit loss (5%) | −$2,700 |
| Effective gross income | $51,300 |
| Property taxes | −$7,200 |
| Insurance | −$2,400 |
| Repairs and maintenance | −$3,000 |
| Management (8% of income) | −$4,104 |
| Owner-paid utilities | −$1,800 |
| Other operating costs | −$1,000 |
| Net operating income | $31,796 |
| Cap rate ($31,796 ÷ $600,000) | 5.30% |
If you want a 6% cap rate, the same NOI supports a price of about $529,933 ($31,796 ÷ 0.06). Or, at the $600,000 asking price, the building would need $36,000 of NOI to reach 6%, about $4,204 more than it makes now. The sensitivity table in the calculator shows how much value moves with each quarter-point change in cap rate. At this NOI, the gap between a 5% and a 5.25% cap rate is about $30,000 of price.
Edge cases and limits
- If NOI is zero or negative, the cap rate is meaningless. The building loses money before any loan.
- A cap rate is a one-year snapshot. It doesn’t capture rent growth, a coming tax increase or a big repair. For a building with an expiring tax break, check the 421-a and J-51 expiry calculator.
- Cap rates for comparable buildings vary by place, property type and interest rates, and they change over time. We don’t publish “market” cap rates. Compare against recent local sales using the same NOI method.
Next steps
To see your return after the mortgage, use the cash-on-cash return calculator or the rental property cash flow calculator. For a quick first screen before you build a full NOI, try the 1% rule calculator. For tax treatment, read rental income taxes for small landlords.