How to calculate cap rate on a rental property (step by step)
Cap rate = NOI ÷ Purchase price x 100. First calculate NOI (gross rent minus vacancy and all operating expenses, NOT including the mortgage). Then divide by the purchase price. A $350,000 property with $24,500 NOI has a 7.0% cap rate. The calculation takes 10 minutes if you have the expense data.
Cap rate is the first metric most investors learn and the one most frequently miscalculated. The formula itself is simple. The problem is that NOI is not simple, and errors in your NOI flow straight into your cap rate. Getting the expenses right is 90% of the work.
The formula
NOI is the hard part. Purchase price is what you are paying (or the current market value for an existing property).
Step 1: Calculate NOI
NOI = Effective gross income minus all operating expenses.
| Line item | Example |
|---|---|
| Gross rental income | $36,000 |
| - Vacancy (7%) | -$2,520 |
| = Effective gross income | $33,480 |
| - Property taxes | -$4,200 |
| - Insurance | -$1,800 |
| - Property management (9%) | -$3,013 |
| - Maintenance | -$2,160 |
| - CapEx reserves | -$1,800 |
| - Other (pest, lawn, HOA) | -$720 |
| = NOI | $19,267 |
Critical: the mortgage is NOT in this list. NOI deliberately excludes debt service so the result is the same regardless of how you finance. If you include the mortgage, you are calculating cash flow, not NOI.
Step 2: Divide by purchase price
Step 3: Interpret the result
5.5% means the property generates 5.5 cents of net operating income per dollar of value, before financing. Compare this to:
- The local market. Tampa typically runs 5.5% to 7% for SFRs, so this deal is at the bottom of the range. It is not a bad deal, but it is not a bargain either.
- The 10-year Treasury (roughly 4.5%). The risk premium is only 100 basis points. You are accepting very little compensation for the extra work and risk of owning a rental versus holding a government bond.
- Your financing cost. If your mortgage rate is 7.25%, you have negative leverage. The property earns 5.5% but the debt costs 7.25%. Every borrowed dollar drags your return down.
The NOI mistakes that ruin cap rate calculations
- Including the mortgage.The most common error. If your NOI includes debt service, your "cap rate" is actually your cash yield, which is a different and lower number.
- Using the seller's expense numbers. Sellers understate expenses to make the NOI look better. Always rebuild the expense line from actual tax bills, insurance quotes, and market rates.
- Forgetting vacancy. A property is not 100% occupied 365 days a year. Even in tight markets, budget 3% to 5% for turnover.
- Skipping CapEx reserves. The roof, HVAC, water heater, and appliances will all need replacing. If you do not budget for it, your NOI is artificially high and your cap rate is a lie.
- Omitting management fees. Even if you self-manage, include 8% to 10%. Your time has value, and if you ever hire a PM, the deal needs to support it.
- Using the wrong property taxes. Many counties reassess on sale. The current tax bill may be based on a purchase from 15 years ago. Your bill will be based on what you pay.
When cap rate is not the right metric
Cap rate is useful, but it is not universal:
- For comparing financing options: Use cash-on-cash return. Cap rate does not include debt, so it cannot help you choose between two loan offers.
- For total return analysis: Use ROI. Cap rate ignores leverage, paydown, and appreciation.
- For DSCR qualification: Use NOI directly divided by debt service. Cap rate is a derived metric; the lender wants the raw NOI.
- For quick screening: Use GRM. It needs only two inputs versus the full expense breakdown cap rate requires.
Frequently asked questions
How do you calculate cap rate?
Cap rate = NOI divided by purchase price, times 100. NOI is gross rent minus vacancy and all operating expenses (taxes, insurance, management, maintenance, CapEx), but NOT including the mortgage.
Does cap rate include the mortgage?
No. Cap rate uses NOI, which deliberately excludes debt service. This makes cap rate the same for every buyer regardless of financing, which is the entire point of the metric.
What expenses go into NOI for cap rate?
Property taxes, insurance, property management, maintenance, CapEx reserves, vacancy allowance, and any landlord-paid utilities or HOA fees. Do NOT include mortgage payments, income taxes, or depreciation.
Is a higher cap rate better?
Higher cap rate means higher yield relative to price, which is generally better for cash flow. But very high cap rates often signal higher risk (tough market, older property, higher vacancy). Compare within the same market and property class.
Why is my cap rate different from what the seller says?
Probably because the seller used different expense assumptions: lower vacancy, no management fee, no CapEx reserves, or the old property tax bill instead of the post-sale reassessment. Always rebuild NOI with your own expense estimates.
Can cap rate be negative?
Only if NOI is negative, which means operating expenses exceed rental income. This is extremely rare for a stabilized rental and would indicate a property that loses money even without a mortgage.