How to Calculate Cap Rate on Rental Property
The complete guide to capitalization rate — the single most important number in rental property investing.
Cap rate is the first thing experienced real estate investors look at when evaluating a deal. It tells you what percentage return a property generates on its purchase price, stripping out financing so you can compare properties on a level playing field.
If you only learn one formula in real estate investing, make it this one. Here's everything you need to know — the formula, a step-by-step example, what counts as a "good" cap rate, and the mistakes that trip up new investors.
The Cap Rate Formula
That's it. Two numbers — your annual net operating income (NOI) divided by the price you're paying for the property. The result is a percentage that tells you your unleveraged return.
The key word is unleveraged. Cap rate assumes you're paying all cash. It doesn't factor in your mortgage, down payment, or loan terms. That's by design — it lets you compare a $150,000 duplex in Memphis to a $600,000 triplex in Austin on equal terms.
Step-by-Step Example
Let's walk through a real example. Say you're looking at a rental property listed at $250,000 that rents for $1,500 per month.
Step 1: Calculate gross rental income
$1,500/month × 12 months = $18,000/year in gross rent.
Step 2: Subtract vacancy
No property stays rented 365 days a year forever. A realistic vacancy factor is 5–8%. Using 6%: $18,000 × 0.94 = $16,920 effective gross income.
Step 3: Calculate annual operating expenses
Operating expenses include everything you pay to own and maintain the property except your mortgage. The major categories are property taxes, insurance, repairs, property management fees, and any utilities you cover as landlord.
For this example, let's say annual expenses total $6,420 — roughly $535/month covering property taxes ($200), insurance ($100), maintenance ($120), and management ($115).
Step 4: Calculate NOI
$16,920 effective income − $6,420 expenses = $10,500 NOI
Step 5: Divide by purchase price
$10,500 ÷ $250,000 = 0.042 = 4.2% cap rate
What's a Good Cap Rate?
This is the most common question investors ask, and the honest answer is: it depends on what you're optimizing for.
Above 8% — Excellent cash flow, but these deals typically come with trade-offs. The property might be in a rougher neighborhood, an older building needing significant maintenance, or a market with flat or declining population. High cap rates are a risk premium — the market is telling you something.
5% to 8% — The sweet spot for most residential investors. You're getting meaningful cash flow while investing in markets with solid fundamentals. Many of the best cash-flow markets in the South and Midwest fall in this range.
3% to 5% — Common in higher-priced metros like Denver, Nashville, and Raleigh. Investors here bet more on appreciation than cash flow. The deal might barely break even monthly but could generate significant wealth through equity growth over 10+ years.
Below 3% — Tough to make the math work for pure investment purposes. Markets like Seattle, San Francisco, and Bozeman frequently show cap rates under 3%. These are appreciation plays requiring longer time horizons and more capital.
We track cap rates across 300+ US cities so you can see exactly where each market falls.
What Counts as an Operating Expense?
Getting expenses right is where most cap rate calculations go wrong. Here's what to include and what to leave out.
Include: property taxes, property insurance, repairs and maintenance (budget 8–10% of gross rent), property management fees (8–12% of rent, even if you self-manage — your time has value), vacancy loss, HOA fees if applicable, landscaping, pest control, and any utilities you pay as landlord.
Don't include: mortgage payments (principal or interest), income taxes, depreciation, capital expenditures (roof replacement, HVAC), or one-time closing costs. Cap rate is an operating metric — it measures the property's performance, not your financing or tax situation.
The 50% Rule Shortcut
Don't have detailed expense data yet? The 50% rule provides a quick estimate: operating expenses typically run about 40–50% of gross rent for residential properties.
For our $250,000 example: $18,000 gross rent × 50% = $9,000 estimated expenses. NOI = $9,000. Cap rate = $9,000 ÷ $250,000 = 3.6%.
The 50% rule is a screening tool, not a substitute for real analysis. Once you're serious about a deal, get actual numbers for taxes, insurance, and projected maintenance.
Cap Rate vs Other Metrics
Cap rate vs cash-on-cash return: Cap rate ignores financing. Cash-on-cash return measures your return on actual cash invested, including leverage. A property with a 5% cap rate might produce a 12% cash-on-cash return with favorable financing — or a 2% return if rates are punishing.
Cap rate vs the 1% rule: The 1% rule is a quick screening filter — monthly rent should be at least 1% of price. Cap rate is more thorough because it accounts for expenses and vacancy.
Cap rate vs GRM (Gross Rent Multiplier): GRM is price divided by annual gross rent. Faster to calculate than cap rate but doesn't account for expenses. A property with low taxes will have the same GRM but a significantly better cap rate than one with high carrying costs.
Three Mistakes That Wreck Cap Rate Calculations
1. Using asking price instead of offer price
Cap rate uses the price you actually pay, not the listing price. If you negotiate $250,000 down to $230,000, your cap rate jumps from 4.2% to 4.6%. Always recalculate at your offer price — that's the number that matters.
2. Using market rent instead of actual rent
If there's a tenant in place paying $1,300 when market rent is $1,500, your cap rate is based on $1,300. You can calculate a "pro forma" cap rate at market rent to see upside potential, but the cap rate at current rent is what you're actually buying.
3. Underestimating maintenance
Older properties eat investors alive on maintenance. A 1960s building with original plumbing, an aging roof, and a 15-year-old HVAC system will cost far more than the standard 8–10% of rent. For older properties, budget 12–15% or more — and keep a separate capital expenditure reserve for the big-ticket items.
When Cap Rate Doesn't Tell the Full Story
Cap rate is powerful but not perfect. It's a snapshot metric — it tells you about today, not tomorrow. Here are situations where cap rate alone can mislead you:
Value-add properties: A run-down building might have a terrible cap rate at current rents but fantastic potential after renovation. BRRRR investors specifically look for low cap rates they can fix through rehab.
High-growth markets: A 3% cap rate in a city growing at 4% annually might outperform a 7% cap rate in a declining market over a 10-year hold. Cap rate doesn't capture appreciation.
Rent growth potential: Markets where rents are climbing 5–6% per year will look very different in three years. Today's mediocre cap rate could be excellent once rents catch up.
The best investors use cap rate as a starting point, then layer on cash-on-cash return, appreciation forecasts, and market fundamentals to build the full picture.