How cap rate is calculated
Cap rate is net operating income divided by the purchase price. Net operating income is a full year of rent minus a full year of operating expenses, and the expenses are where people go wrong.
Operating expenses means property taxes, insurance, repairs and maintenance, management, and a realistic vacancy allowance. It does not include your mortgage payment or the interest on it. That exclusion is the point: cap rate ignores how the deal is financed so two buildings can be compared as buildings, not as loans.
- Net operating income = twelve months of rent minus a year of operating expenses
- Cap rate = net operating income divided by purchase price
- Leave the mortgage out entirely
- Include a vacancy allowance, or the number is fiction
What a good cap rate is depends on where you are
There is no universal good cap rate, and anyone quoting one without naming a market is guessing. A 4% cap can be entirely normal in an expensive coastal city where buyers are paying for appreciation, and a disaster in a flat market where the only return you will ever get is the rent.
Use cap rate the way it is meant to be used: to compare properties against each other in the same city, at the same time, priced by the same kind of buyer. Comparing a cap rate in one metro against a cap rate in another tells you about the two markets, not about the two buildings.
The expense number is the one people fake
A listing showing a strong cap rate has almost always been built on optimistic expenses. Common omissions are vacancy, capital items such as a roof or a water heater that will certainly need replacing, and the cost of management, which exists even when you do it yourself for free.
Before you trust somebody else's cap rate, rebuild it with your own expense number. If you already own the property, use what you actually spent last year. RentCaddie's expense tracking gives you that figure per property.
A worked example
A single-family rental listed at $180,000 rents for $2,100 a month. Taxes, insurance, maintenance and a vacancy allowance come to $6,800 for the year.
- Purchase price
- $180,000
- Yearly rent (12 times $2,100)
- $25,200
- Yearly operating expenses
- $6,800
- Net operating income
- $18,400
Add a $3,000 roof reserve to the expenses and the same building drops to 8.56%. That is the whole reason to rebuild somebody else's expense number rather than accept it.
Common questions
Is the mortgage included in a cap rate?
What expenses belong in net operating income?
Should I use market rent or the rent it collects today?
Does a higher cap rate always mean a better deal?
These calculators are educational and are not legal, tax, lending, or accounting advice. Rules vary by state and by city, and your lease governs your own properties. Check your own requirements before relying on any number here.