How to Calculate Cap Rate: Formula, Examples & Common Mistakes
The cap rate formula is simple. Getting the inputs right is where most investors go wrong. Three real examples using actual city data.
Cap rate is the single most used metric in rental property investing — and also one of the most frequently miscalculated. The formula itself is straightforward, but the inputs require precision. Get NOI wrong by even 10% and your cap rate shifts from "solid deal" to "money pit."
Here's exactly how to calculate cap rate correctly, with three real-world examples using actual market data from cities in our 775-city database.
The Cap Rate Formula
That's it. Two numbers, one division. But each of those numbers contains multiple components that you need to get right.
Net Operating Income (NOI) — What It Includes
NOI is your annual gross rental income minus all operating expenses. Here's what goes into it:
Gross rental income: The total annual rent the property generates. If the property rents for $1,200/month, that's $14,400/year in gross potential rent.
Minus vacancy allowance: No property is rented 365 days a year, every year. Budget 5%–8% for vacancy and turnover. In our example: $14,400 x 0.93 (7% vacancy) = $13,392 effective gross income.
Minus operating expenses: Property taxes, insurance, maintenance/repairs (budget 8%–12% of rent), property management fees (8%–10% of collected rent), and any landlord-paid utilities. These typically total 35%–50% of gross rent depending on the market and property age.
What NOI does NOT include: Mortgage payments, loan interest, depreciation, capital expenditures (roof replacement, HVAC systems), and income taxes. These are financing and tax decisions that vary by investor — cap rate strips them out so you can evaluate the property on its own merits.
Example 1: Memphis, TN — High Cash Flow Market
You're looking at a 3-bedroom, 1-bath ranch in Memphis listed at $140,000. Recent comps show similar properties renting for $1,100/month.
Gross annual rent: $1,100 x 12 = $13,200
Vacancy (7%): -$924
Effective gross income: $12,276
Operating expenses:
Property taxes: $1,680/year ($140/mo)
Insurance: $1,080/year ($90/mo)
Maintenance (10% of rent): $1,320/year
Property management (9%): $1,105/year
Total expenses: $5,185/year
NOI: $12,276 - $5,185 = $7,091
Example 2: Austin, TX — Appreciation Market
A 3-bedroom, 2-bath home in Austin listed at $380,000. Market rent for comparable properties: $1,800/month.
Gross annual rent: $1,800 x 12 = $21,600
Vacancy (5%): -$1,080
Effective gross income: $20,520
Operating expenses:
Property taxes: $7,600/year (Texas has high property taxes — roughly 2% of value)
Insurance: $1,920/year ($160/mo)
Maintenance (8% of rent): $1,728/year
Property management (8%): $1,642/year
Total expenses: $12,890/year
NOI: $20,520 - $12,890 = $7,630
A 2.0% cap rate means this property barely covers operating costs. After a mortgage, you'd lose money every month. Austin investors are betting on appreciation — home values there have grown roughly 6%–8% annually over the past decade, which on a $380K property is $23K–$30K per year in equity. That dwarfs the cash flow gap, but only if appreciation continues. Use MortgageMathLab.com to see how different mortgage terms affect your monthly payment.
Example 3: Indianapolis, IN — The Balanced Play
A 3-bedroom, 1.5-bath in Indianapolis listed at $180,000. Market rent: $1,300/month.
Gross annual rent: $1,300 x 12 = $15,600
Vacancy (6%): -$936
Effective gross income: $14,664
Operating expenses:
Property taxes: $1,800/year
Insurance: $1,200/year ($100/mo)
Maintenance (9% of rent): $1,404/year
Property management (9%): $1,320/year
Total expenses: $5,724/year
NOI: $14,664 - $5,724 = $8,940
At 5.0%, Indianapolis sits in the balanced zone — you'll likely get modest positive cash flow after financing (depending on your rate and down payment), plus the market has been growing 4%–5% annually. It's the kind of deal where neither the yield nor the appreciation is extraordinary, but together they produce solid total returns. Compare Indianapolis against other markets using our city comparison tool.
The 5 Most Common Cap Rate Mistakes
1. Including Mortgage Payments in NOI
This is the most frequent error. Your mortgage payment is a financing cost, not an operating expense. Cap rate is designed to evaluate the property independent of how you finance it. If you include the mortgage, you're calculating something — but it's not cap rate. For evaluating a deal with financing, use cash-on-cash return instead.
2. Using Asking Rent Instead of Market Rent
Sellers and listing agents love to quote the highest rent the property could theoretically achieve. Use actual market comps — what similar properties in the same neighborhood are currently renting for. Check Zillow, Rentometer, and local property management companies for real data. A $100/month overestimate on rent inflates your cap rate by 0.5–0.8 percentage points.
3. Ignoring Vacancy
Using 100% occupancy in your calculation is fantasy. Even in tight rental markets, you'll have turnover, make-ready time between tenants, and occasional extended vacancies. Budget 5% minimum in strong markets, 7%–10% in softer ones. Not doing so inflates your cap rate by roughly 0.3–0.6 points.
4. Forgetting Property Management Fees
"I'll manage it myself" is a plan, not an expense reduction. Always calculate cap rate with property management included (8%–10% of collected rent). If you choose to self-manage, that's free labor you're donating to the investment — but the property's intrinsic cap rate shouldn't change based on whether you work for free. Also consider the impact on your taxes at TakeHomeTax.com.
5. Using Purchase Price Instead of True Acquisition Cost
If you're buying a property that needs $20,000 in repairs before it's rent-ready, your true cost basis is purchase price plus rehab, not just the purchase price. A $120,000 property needing $20,000 in work that rents for $1,100/month has a very different cap rate calculated on $140,000 total cost than on $120,000. Use the all-in number.
When Cap Rate Isn't Enough
Cap rate is essential but incomplete. It tells you nothing about financing terms, tax benefits, appreciation potential, or total return. A property with a 4% cap rate in a market appreciating 6% annually produces better total returns than a 7% cap rate property in a flat market — but cap rate alone won't show you that.
Use cap rate for initial screening and comparison. Then layer on cash-on-cash return for financing analysis, the 1% rule for quick filtering, and total return projections for your final decision. Browse our top-ranked markets to find cities that perform well across multiple metrics.