Cap rate formula
- Cap rate: yearly net operating income divided by the property price, presented as a percentage
- Example: a $300,000 rental with $18,000 of net operating income each year gives a 6% cap rate
- Not included: mortgage payments, income tax, depreciation and major improvements you pay for only once
The cap rate formula divides one year of a property's net operating income by the property's price. The answer is a percentage figure. NOI, short for net operating income, equals the rent you actually collect in a year minus the yearly costs of running the property. For a $300,000 rental with $18,000 in yearly NOI, the cap rate comes to 6%. You may also see it called the cap rate equation, and British sites spell it capitalisation rate, but it's all the same thing. Wikipedia's entry on capitalization rate explains this further.
How to work out a cap rate
You need 3 items: annual rent collected, yearly property expenses and the price. After finding the NOI, divide it by the price. This shows how much annual income the property produces for each dollar spent.
Use either the asking price or the property's market value, which is what it would sell for today.
The calculator on the cap-rate.com home page does the math for you from the price, the rent and the yearly costs, and it fills in tax and insurance figures from your ZIP code if you don't type your own.
Small and large properties
Small or large, the property doesn't change the method. Here are two examples side by side.
| Property | Price | Yearly income | Rate |
|---|---|---|---|
| Small rental | $300,000 | $18,000 | 6% |
| Larger multi-unit property | $2,000,000 | $150,000 | 7.5% |
Higher cap rates bring more annual income per dollar of price and normally carry greater risk. A lower cap rate suggests a more expensive property that is generally safer, according to Wikipedia.
Step by step
- Total the rent you collect over a full year.
- Take away the rent lost to vacancy, since you never receive that money while the property stands empty, so it does not count.
- Subtract the yearly operating costs; the amount left over is your NOI.
- Divide that NOI by the purchase price, then read the answer as a percentage.
For this $300,000 rental, $18,000 in NOI works out to a 6% cap rate.
Which costs count?
Operating costs are the everyday bills of running the place: property tax, insurance, maintenance and repairs, fees for management, and any utilities you cover as the owner. HOA dues (the monthly fees paid to the homeowners association) count too.
Several costs stay outside NOI. One is the mortgage payment, which covers both principal and interest. Income tax, depreciation and big one-off improvements are also left out. Depreciation is the tax write-off for wear on the building. The IRS Publication 527 classifies depreciation and mortgage interest as tax items instead of operating expenses.
Leaving out the loan keeps the calculation focused on the property rather than the buyer. This means 2 buyers with very different loans will find the same cap rate for that property.
Working the formula backwards
Reversing the same formula helps answer 2 other questions.
To find value, divide NOI by the cap rate: $18,000 ÷ 6% = $300,000.
To work out the NOI, multiply the property price by the cap rate: $300,000 × 6% = $18,000.