How to Calculate Cap Rate (And What It Leaves Out)

Start with everything the property should collect in a year if it never sat empty. That is rent, plus any other recurring income the property produces — parking, storage, laundry, pet rent.

A unit at 2,200 a month is 26,400 a year. Use the rent you can actually achieve, not the rent you hope for; an optimistic starting number contaminates every figure downstream.

No property is occupied every day forever. Tenants leave, units need turning over, and some months are lost. A vacancy allowance is the share of gross income you expect not to collect.

At a 5% allowance, 26,400 becomes 25,080. This is your effective gross income. Setting vacancy to zero is the single most common way to make a mediocre deal look good on a spreadsheet.

The right number is local. Letting agents and published market data beat any default, and it varies enormously between a student let and a long-term family rental.

Operating expenses are the recurring cost of running the property: property tax, insurance, repairs and maintenance, management fees, HOA or service charges, and any utilities the owner covers.

With 8,400 of annual operating expenses, effective gross income of 25,080 leaves net operating income of 16,680.

Four things stay out, and this is where most errors happen: the mortgage payment, capital expenditure, depreciation, and income tax.

This feels wrong the first time you see it. The mortgage is real money leaving your account every month, so why would a measure of a property's return ignore it?

Because the cap rate exists to compare buildings, not buyers. Two people can buy the identical property at the identical price — one with cash, one with 80% leverage — and they face completely different mortgage payments. If financing were included, they would compute different cap rates for the same building, and the number would be useless for comparison.

By excluding debt service, the cap rate describes the asset. Cash-on-cash return describes your position in it. You need both, and they answer different questions.

Net operating income of 16,680 against a 250,000 price gives 16,680 ÷ 250,000 × 100 = 6.67%.

Now run it the other way. Because cap rate is NOI divided by value, value is NOI divided by cap rate. That same 16,680 of income is worth 278,000 at a 6% cap rate and 208,500 at 8%.

Nothing about the building changed between those two numbers — only the return a buyer in that market demands. This is the income approach to valuation, and it is why identical properties are worth different amounts in different cities.

First, when you read a high cap rate as a bargain. Cap rates are generally higher where risk is higher. A rate well above the local norm usually means the market has priced in something — vacancy risk, deferred maintenance, a declining area — rather than that everyone else missed a deal.

Second, when capital expenditure is ignored. Cap rate excludes the roof, the boiler and the rewire. Those arrive every fifteen years rather than every month, but they are real, and a property that looks fine on cap rate can lose money once you reserve for them properly.

Third, when comparing across markets or dates. A 5% cap rate in one city and an 8% in another may reflect growth expectations and interest rates rather than one being better. Cap rates are only meaningful between similar properties, in the same market, at the same time.