The cap rate formula is one of the simplest calculations in real estate investing, but it's easy to get wrong because the inputs — net operating income and property value — are themselves easy to miscalculate. Get the formula right and it becomes a fast way to compare rental properties; get the inputs wrong and it will mislead you no matter how carefully you do the division.
The Formula
Cap Rate = Net Operating Income (NOI) ÷ Current Market Value
Both sides of the equation need to be annual figures, and the result is expressed as a percentage. That's the entire formula — the difficulty is almost always in calculating NOI correctly, not in the division itself.
Calculating NOI the Right Way
Net operating income is the property's annual income after operating expenses, but before debt service, capital expenditures, and depreciation. Leaving any of those three out — or accidentally including them — is the most common source of a wrong cap rate.
- Start with gross rental income and any other income the property generates (parking, laundry, storage).
- Subtract a realistic vacancy allowance even if the property is currently fully occupied.
- Subtract operating expenses: property taxes, insurance, property management, repairs and maintenance, utilities the owner pays, and reserves for turnover.
- Do not subtract the mortgage payment, principal, or interest — cap rate is meant to measure the property's performance independent of how it's financed.
- Do not subtract depreciation — that's an accounting concept, not a cash expense.
Worked Example (Illustrative)
These numbers are illustrative only, used to show how the formula works:
- Property purchase price: $250,000
- Gross annual rental income: $30,000
- Vacancy allowance (5%): -$1,500
- Operating expenses (taxes, insurance, management, maintenance): -$10,500
- Net Operating Income: $18,000
Cap Rate = $18,000 ÷ $250,000 = 7.2%
Rearranging the Formula to Find an Offer Price
Investors often flip the formula around when they already know the target cap rate for a market or asset class and want to back into a maximum purchase price:
Value = NOI ÷ Target Cap Rate
Using the example above, if you wanted at least a 7.2% cap rate and you know the property's NOI is $18,000, the math tells you not to pay more than $250,000 for it — a useful sanity check before you make an offer.
Common Mistakes With the Formula Itself
- Mixing purchase price and current market value. If you're evaluating a property you already own, use current market value, not what you paid for it years ago — otherwise the cap rate no longer reflects today's return.
- Using pro forma or "projected" rent instead of actual or realistic market rent, which inflates NOI and understates risk.
- Forgetting property management costs even when you plan to self-manage — a cap rate should reflect what the property could earn for any owner, not just one who works for free.
For the broader concept of what cap rate is used for and its limitations, see our guide on cap rate. For several worked scenarios side by side, see cap rate examples.