Learning how to calculate a rental property’s cap rate helps you evaluate its potential income, weigh it against other investment opportunities, and make more pragmatic decisions.
Failure to consider a property’s cap rate can come at a steep cost, as you could end up overpaying, underestimating risk, or falling short of anticipated returns.
Keep reading to arm yourself with valuable information that will help you avoid the dreaded scenarios above. To assist, we’ll discuss how to calculate capitalization rate, crucial factors to consider, common mistakes to avoid, and more.
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Capitalization rate (also known as cap rate) is a real estate calculation used to determine an investment property’s rate of return based on its current market value and net operating income.
By calculating a property’s cap rate, you’ll produce a statistic that indicates how much income a property will produce relative to its market value. This key metric will enable you to make decisions based on actual, proven numbers (not gut feelings or instinct).
Significantly, financing (mortgage amount, interest rates, equity, etc.) does not factor into calculating a property’s cap rate.
The quick formula for calculating cap rate is:
Cap Rate = Net Operating Income (NOI) ÷ Property Value
While the equation above may seem simple, making an accurate calculation means first correctly calculating your property’s NOI and value.
Taking the time to do so is paramount for analyzing a property’s income-earning potential, which can guide future real estate investment decisions. We’ll discuss this topic further in the following sections.
Calculating an accurate cap rate will help you make a well-informed decision based on actual, proven numbers.
Making an inaccurate property calculation could lead to:
Exercise due diligence as you calculate a property’s cap rate. Accurate, provable numbers are key and will help you to act confidently and make savvy investment decisions that grow your portfolio.
We’ll start by calculating NOI.
Net operating income is determined by taking a property’s gross operating income and subtracting its operating expenses:
Net Operating Income = Gross Operating Income – Operating Expenses
Gross operating income is calculated by taking a property’s potential rental income, adding its other income, and subtracting its vacancy loss:
Gross Operating Income = Potential Rental Income + Other Income – Vacancy Loss
Potential rental income measures the total base rent amount you would collect if the investment property stays occupied year-round at current market rates.
Other income is revenue that a property generates outside of base rent. A few examples are:
Vacancy loss measures the estimated income lost due to vacancies or unpaid rent, typically represented as a percentage.
Operating expenses measure all recurring costs required to keep an investment property running. A few examples are:
Now that you understand the factors influencing a property’s NOI, let’s dive into the different methods to determine its market value.
You have a handful of tried-and-true options to determine a rental property’s market value. Here are three of the top approaches:
Analyze the sales prices of comparable properties in the neighborhood, and consider their type, size, condition, and location relative to the property in question. Make price adjustments based on key differences between the properties, and come up with an educated estimate.
Generally, this approach is more accurate if there have been multiple recent sales of comparable properties within close proximity.
Obtaining a BPO (broker’s price opinion) from a trusted real estate professional can provide insight into a property’s value. Active brokers typically have their finger on the pulse of the real estate market and can estimate property values with reasonable accuracy.
Certified property appraisers have one job and one job only: to provide an unbiased opinion of a property’s market value using several proven methods. Of the options on this list, going this route usually produces the most accurate market value estimate, but costs the most.
Now that we have the NOI and market value, we can calculate the cap rate for a property.
As a reminder, the formula for calculating cap rate is:
Cap Rate = Net Operating Income (NOI) ÷ Property Value
For context, let’s pretend you’re considering purchasing an investment property valued at $500,000.
When sitting down with the seller, they open up their books and show you that the property had a net operating income of $40,000 and accrued $5,000 in operating expenses over the last year. Their projections, which seem rock-solid, point to a similar year ahead.
By taking the property’s $40,000 NOI and subtracting its $5,000 in operating expenses, we determine the property’s NOI is $35,000.
As mentioned, the property’s value is $500,000.
Because property value and NOI are the only two metrics used to determine cap rate, we can now make our calculation:
$35,000 (NOI) ÷ $500,000 (Property Value) = 7% (Cap Rate)
Is that good or bad? Let’s find out.
After calculating a property’s cap rate, you may wonder what to make of the number itself. Below are the typical cap rate brackets and how to interpret properties that fall into them.
Cap rates below 5% typically represent stable, low-risk properties in proven locations. These properties usually offer dependable rental income and long-term appreciation potential, but limited immediate returns. You’ll pay a premium for predictability and location when purchasing properties with low cap rates.
Example: San Francisco, California (3.8%)
Typically, properties between a 5% and 7% cap rate strike a balance between income-earning potential and risk. They usually exist in decent real estate markets, show reasonable upside, and are attractive if you’re after a steady cash flow with room for growth.
Example: Denver, Colorado (5.5%)
High cap rates indicate that a property has potential for more substantial cash flow, but often comes with higher risks. These properties may have pressing maintenance needs, higher vacancy rates, or exist in unstable markets. If you’re a sweat equity investor who conducts hands-on property management, these properties may appeal to you.
Example: Memphis, Tennessee (8.2%)
Both property-specific details and overall market conditions determine cap rates. Understanding all the factors at play will help you evaluate risk, compare deals with a high degree of accuracy, and decide whether a property’s potential return matches your investment goals.
Properties in desirable locations with healthy job markets usually result in lower cap rates. Investors in these areas often accept lower returns in exchange for long-term stability, whereas riskier locations require higher cap rates to drum up interest and offset doubt.
Crowded urban markets like San Francisco and New York City often see lower cap rates due to high housing demand and limited supply. In contrast, rural and suburban areas tend to carry higher cap rates due to weaker demand, longer vacancy periods, and pricing volatility.
With different property types come different risks. Multifamily rental units, for instance, typically carry lower cap rates than commercial properties because they have more consistent demand and quicker tenant turnover.
Property size also plays a big part in cap rate. Larger properties (like industrial warehouses) often require more capital to rent, which can drive cap rates higher. Alternatively, smaller residential rentals attract more interested parties, leading to lower, more stable cap rates.
Long-term tenancies offer landlords predictable and consistent cash flow. As such, properties with reliable tenants on fixed-term leases often sell at lower cap rates. In contrast, properties with month-to-month tenants typically present a higher risk, pushing cap rates higher.
Lease terms also significantly impact cap rate. Triple net (NNN) properties, where tenants cover operating costs, typically reduce landlord risk and lower the cap rate. Properties where the landlord pays for the bulk of expenses shift risk back onto them, and thus push the cap rate higher.
Higher vacancy rates across an area usually signify that a market has weak demand or is oversupplied, which increases risk and, as a result, cap rates. Low-vacancy markets typically mean you can rely on steady income driven by high housing demand, which, you guessed it, decreases cap rates.
A specific property’s vacancy statistics play a part, as well. Steady tenant turnover or long gaps between leases suggest a property has pressing issues you might need to address. Even in strong markets, properties with higher vacancy rates typically result in higher cap rates.
Newer or well-maintained properties usually come with lower cap rates. The need for fewer repairs means more predictable operating costs and an overall lower risk. Older buildings with deferred maintenance may require higher returns to justify future expenses.
While some properties seem profitable, they may require significant maintenance that will eat into a property’s NOI. As such, you should run properties through thorough inspections and adjust cap rate expectations based on estimated repair risks and recurring maintenance costs.
As you may imagine, cap rates vary significantly across U.S. markets. To provide perspective, we’ve highlighted estimated 2025 cap rates across 15 major U.S. cities in the table below.
| City | Average Cap Rate % |
|---|---|
| San Francisco, CA | 3.8 |
| New York, NY | 4.1 |
| Los Angeles, CA | 4.4 |
| Seattle, WA | 4.6 |
| Boston, MA | 4.8 |
| Washington, D.C. | 5.7 |
| Atlanta, GA | 5.9 |
| Chicago, IL | 6.2 |
| Dallas, TX | 6.5 |
| Phoenix, AZ | 6.8 |
| Houston, TX | 7 |
| Kansas City, MO | 7.3 |
| Cleveland, OH | 7.6 |
| Memphis, TN | 8.2 |
Cap rate is only as accurate as the numbers within its equation. While a poorly calculated cap rate can be harmful, it’s also easy to avoid.
Here are some of the most common missteps to consider when calculating cap rate:
Gross income doesn’t account for property-related expenses like taxes, property management costs, insurance premiums, and repairs. NOI gives a clearer picture of what the property actually earns, because it factors in predictable expenses you can prepare for.
While we love to dream about a 100% occupancy rate and tenants who always pay rent on time, the reality isn’t so rosy. Even in strong markets, vacancies and missed payments always occur. Failing to account for them will inflate your NOI and predict a cap rate that’s too optimistic.
If you self-manage your rental property, you must account for accurate property management costs when calculating the cap rate. Time is money, and you may consider hiring a property manager. Consider using software to offload the tedious, manual tasks that property managers charge high rates to complete.
Cap rate reflects the potential return on today’s investment. Using a property’s past purchase price instead of its current market value will alter its cap rate stats, especially if it has taken a significant leap in value since its last purchase.
Cap rate, when properly calculated, can give you a reliable estimate of a property’s income-generating potential. Understanding this simple statistic will help you push aside gut feelings and focus on actual numbers and the story they tell.
Now that you have a firm grasp on cap rate, how to calculate it, and what the numbers signify, use that knowledge to your benefit. Remove emotion from the equation, make informed investments, and watch your portfolio take flight.
One surefire way to increase your investment property’s NOI is to enlist software to streamline the entire property management process on your behalf. Rather than hiring a property manager, use DIY property management software to help you get the job done at a fraction of the cost.
TurboTenant, our easy-to-use, free landlord software, can help you:
Sign up for a free TurboTenant account today to instantly upgrade your real estate investment operation.
“Good” is a subjective term, and its interpretation depends on a real estate investor’s unique goals. For instance, a risk-averse investor might prefer a low cap rate in a stable market with steady returns. A value-add investor may seek higher cap rates that signal more cash flow potential, albeit with added risk.
No. Although cap rate and ROI are related, they are not the same. Cap rate only considers a property’s NOI and market value, whereas ROI considers a property’s total investment costs, financing terms, and tax-related factors.
In essence, cap rate will help you evaluate properties by removing financing from the equation, whereas ROI directly relates to the capital invested into a property.
No. As with the previous comparison, cap rate doesn’t factor in financing considerations like debt service, which represents the total amount of money needed to repay a loan in full.
In an ideal scenario, yes. A higher cap rate than the mortgage interest rate implies that the investment property generates enough income to cover its debt service. In turn, this means it likely produces positive cash flow, which is known as positive leverage.
Profitability depends on many factors, as every property is unique and markets fluctuate daily. That said, multifamily properties, short-term rentals, and value-add investments traditionally offer you the highest potential returns.
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