Cap rate formula
The formula is one division. The difficulty is in the top line, which is a number you have to build, and in choosing what goes on the bottom.
Cap rate = net operating income ÷ property value.
Net operating income is what the building earns in a year after vacancy and after the costs of running it, and before any loan. Property value is what you paid, or what it is worth today, depending on the question you are asking.
The result is a yield on the property itself. It says nothing about how the property is financed, which is exactly why it is used to compare one building with another.
Worked through
Start from the rent and work down to NOI before dividing anything. This is the same building used in the other guides here: $600,000, with the income and expenses laid out the way an operating statement does it.
| Operating statement | Year one |
|---|---|
| Gross scheduled rent | $60,000 |
| Less vacancy at 5% | -$3,000 |
| Effective gross income | $57,000 |
| Less operating expenses | -$21,000 |
| Net operating income | $36,000 |
| Purchase price | $600,000 |
| Cap rate | 6.0% |
Two things are worth noticing in that statement. The rent is reduced for vacancy before any expense is subtracted, because a vacant unit collects nothing but still costs money to hold. And the operating expenses are the costs of running the property, not the cost of owning it: no mortgage payment, no income tax, no depreciation, and no large capital replacement such as a new roof.
Turning it around
The formula rearranges into two other forms, and you will use the second one more than the first.
- Net operating income = cap rate × property value. What a property should earn if it is priced at a given yield.
- Property value = net operating income ÷ cap rate. What income is worth, if the market accepts a given yield.
The second form is how income properties are valued, and it is worth seeing what it does. Here is one NOI at three different cap rates.
| If the market prices this NOI at | The property is worth |
|---|---|
| 5.0% | $720,000 |
| 6.0% | $600,000 |
| 7.0% | $514,286 |
On this building a single percentage point moves the value by more than a tenth of the price. That sensitivity is the reason two buyers can disagree about a price without disagreeing about the income, and it is why the cap rate assumed in a valuation deserves as much scrutiny as the income it is applied to.
Which value goes on the bottom
There are two answers, and they are different questions.
- Purchase price, when you are analyzing an acquisition. It gives the yield you would be buying at, sometimes called the going-in cap rate.
- Current market value, when you already own the building and are asking what it yields against what it is worth today.
The same building has a different cap rate under each, and comparing one against the other is a category error. A going-in cap rate compared to a market figure computed on current value is comparing two things that were never on the same footing. The cap rate calculator asks which one you mean instead of assuming.
Where it goes wrong
A cap rate can be wrong while the division is right. Each of these is correct division of the wrong number, and each yields a figure that looks entirely reasonable in isolation.
| What went on top of the fraction | The cap rate it produces |
|---|---|
| Gross rent on top instead of NOIEvery expense left out. | 10.0% |
| Vacancy forgottenRent counted as if every unit were full all year. | 6.5% |
| The mortgage payment counted as an expenseDebt service belongs to the loan, not the building. | -0.1% |
| Net operating incomeThe correct figure. | 6.0% |
The first is the one to watch for in a listing. Gross rent divided by price is an easy number to compute from a flyer, and it will exceed the real cap rate whenever the building has any operating costs, which is always. The third version, with the loan in the expenses, is a different failure: it produces a cap rate that changes when the interest rate does, which a property's yield never should.
There is also the quieter problem underneath all of these: the input to the top line may itself be wrong. A cap rate built on projected rent, a vacancy allowance of zero, or expenses that omit management and reserves is correct arithmetic on flattering inputs. What is a good cap rate lists four checks to run on a quoted figure before trusting it.
What the formula leaves out
Cap rate is a single-year, unlevered, pre-tax yield. It contains no loan, so it cannot tell you whether the property carries its debt or what your own cash earns. It includes no appreciation and no tax treatment. And it uses one year's income, so it reads a building at one moment rather than over the time you will own it.
Those are not defects. They are what makes it comparable across buildings, and the reason there are other numbers for the other questions. Cap rate versus cash-on-cash return shows what happens to the same building once a loan is added.