The formula
Net operating income (NOI) = rent collected after vacancy and bad debt, plus other income such as parking or laundry, minus operating expenses. Operating expenses include property tax, insurance, repairs and maintenance, management, landlord-paid utilities and a reserve for replacements. They exclude mortgage payments, depreciation and income tax. For the difference between NOI and cash flow, see net operating income in the glossary.
Cap rate = NOI ÷ value × 100. Value at a target cap rate = NOI ÷ target cap rate.
A worked example
A small building valued at 400,000 rents for 3,000 a month in total. Allow 5% for vacancy and bad debt and add 1,200 a year from parking, and effective gross income is 36,000 × 0.95 + 1,200 = 35,400. Operating expenses of 12,600 leave an NOI of 22,800, for a cap rate of 22,800 ÷ 400,000 = 5.70%.
If buyers in that market expect 6%, the same income supports a value of 22,800 ÷ 0.06 = 380,000. A higher expected cap rate means a lower price for the same income, which is why rising interest rates tend to push values down.
Cap rate versus cash-on-cash return
Cap rate describes the property; cash-on-cash return describes your investment in it, after financing. A 5.7% cap rate can produce a much higher or lower return on your own cash depending on the deposit and the interest rate. Use the rental property ROI calculator for that, and the rental yield calculator for a quick gross and net yield.
Common mistakes
Leaving out vacancy, management or a repair reserve makes NOI look higher than it will be. Using the seller’s figures without checking them against leases and bills is the other classic error. Cap rates also vary by area and property type, so compare a property with recent sales of similar ones nearby rather than with a national average.
Once you own the building, the real NOI comes from what it actually earned and spent. Reports track income and expenses per property, and property accounting keeps the ledger behind them, so you can compare the cap rate you bought at with the one you are getting.
Common questions
What is a good cap rate?
There is no single number. Cap rates depend on location, property type, condition and interest rates. Compare with recent sales of similar properties in the same market.
Does cap rate include the mortgage?
No. Cap rate uses net operating income before financing, so properties can be compared regardless of how they are paid for.
How do I calculate NOI?
Rent collected after vacancy, plus other income, minus operating expenses such as tax, insurance, repairs, management and landlord-paid utilities. Exclude mortgage payments, depreciation and income tax.
How do I value a property from its cap rate?
Divide the net operating income by the cap rate expressed as a decimal. An NOI of 22,800 at a 6% cap rate implies a value of 380,000.
Done by hand once. Done automatically from now on.
See the actual income, expenses and occupancy of each property, so the NOI behind your cap rate is measured, not estimated.