Real Estate Glossary
Cap Rate Formula: How to Calculate It (With Examples)
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Definition
The cap rate formula calculates a property's capitalization rate by dividing its annual net operating income (NOI) by its current market value or purchase price, then multiplying by 100 to express it as a percentage. This formula is the standard method used by real estate investors, appraisers, and lenders to evaluate and compare income-producing properties.
The Cap Rate Formula Formula
Variables explained:
Annual NOI = gross annual rent − vacancy loss − all operating expenses (taxes, insurance, maintenance, management, etc.) — but NOT mortgage payments. Property Value = purchase price or current appraised market value. The result is a percentage representing annual yield on the full property value, unaffected by financing.
Cap Rate Formula Example
A fourplex generates $5,200/month in gross rent ($62,400/year). Vacancy at 5% = $3,120 loss. Operating expenses: taxes $5,400, insurance $2,400, management $5,728, maintenance $3,500, misc $600 = $17,628. Annual NOI = $62,400 − $3,120 − $17,628 = $41,652. Purchase price = $620,000. Cap Rate = ($41,652 / $620,000) × 100 = 6.72%.
Why Cap Rate Formula Matters for Investors
The cap rate formula is used in reverse to value properties: Property Value = NOI / Cap Rate. If comparable properties in a market trade at a 6% cap rate and your property has an NOI of $40,000, its implied value is $40,000 / 0.06 = $666,667. This is how commercial real estate appraisers determine value for income-producing properties.
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Frequently Asked Questions
How do you calculate cap rate step by step?
Step 1: Add all annual rent. Step 2: Subtract vacancy (typically 5%). Step 3: Subtract operating expenses (taxes, insurance, maintenance, management). Step 4: The result is NOI. Step 5: Divide NOI by the purchase price. Step 6: Multiply by 100 for the percentage.
What expenses go into the cap rate formula?
Property taxes, insurance, property management fees, maintenance/repairs, HOA/condo fees, utilities paid by owner, landscaping, and a capital expenditure reserve. Do NOT include mortgage principal or interest.
Can you calculate cap rate without knowing operating expenses?
Roughly. Investors sometimes use the "50% rule" — assuming expenses equal 50% of gross rent — for a quick estimate. This is a shortcut, not a precise calculation, but useful for quickly filtering deals.
How is cap rate different from ROI?
Cap rate uses the full property value as the denominator and ignores financing. ROI (return on investment) uses your actual cash invested (down payment + costs) and can include financing effects, appreciation, and equity paydown.
Related Terms
Cap Rate
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