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    How to calculate cap rate for a rental property

    Capitalization rate, line by line. We walk through NOI, gross vs net cap rate, what counts as a good cap rate by market, and the three mistakes that quietly inflate every novice calculation.

    By LariusReviewed by the Handy Calculators editorial teamPublished

    Cap rate is the single most-quoted number in commercial and residential investment real estate — and the single most-misused. Two investors looking at the same building can quote cap rates 150 basis points apart simply because one of them deducted property management and the other didn't. This post walks through the formula the way an appraiser uses it, with a worked example you can replicate in our cap rate calculator.

    The formula, with every line item spelled out

    Capitalization rate = Net Operating Income ÷ Property Value. That looks simple, but the entire argument lives inside NOI. Net Operating Income is the income a property produces in a year after operating expenses but before debt service, before income taxes, and before depreciation. Get the line items wrong and the cap rate is wrong by exactly the same percentage.

    Start with Gross Potential Income — what the property would earn at 100% occupancy and market rent. Subtract a vacancy and credit-loss allowance (typically 5–10% for stabilized residential, more for unstabilized or higher-turnover assets) to get Effective Gross Income. From EGI subtract operating expenses: property taxes, insurance, utilities you pay, repairs and maintenance, property management, lawn care, snow removal, HOA dues, reserves for replacement, leasing commissions, and the legal and accounting fees the property actually generates.

    What you do NOT subtract from NOI: mortgage principal, mortgage interest, depreciation, your personal income taxes, capital improvements, and one-time expenses. Those belong further down the cash-flow waterfall — not in NOI. Lumping them in is the single most common mistake among new investors and is how the same property can show two different cap rates.

    Worked example: a $500,000 duplex in a 6.5% cap-rate market

    You're considering a duplex listed at $500,000. Each unit rents for $1,750/month, so gross potential income is $42,000. Apply a 5% vacancy allowance and effective gross income is $39,900. Operating expenses run to roughly $13,400/year: $5,500 in property taxes, $1,800 insurance, $1,200 water and sewer you pay, $2,000 in repairs and maintenance reserves, $1,200 for landscaping and snow, $1,200 for accounting and legal, and a $500 replacement reserve for the roof and appliances on a pro-rated basis.

    Net Operating Income is $39,900 − $13,400 = $26,500. Cap rate = $26,500 ÷ $500,000 = 5.3%. If the local market for stabilized residential duplexes prices at a 6.5% cap rate, the implied value is $26,500 ÷ 0.065 = $407,692. The seller is asking roughly 23% above what the income supports — either rents are below market and you have an upside story, or the price needs to come down, or the deal doesn't pencil.

    Notice what we did not include: no mortgage payment, no income tax, no depreciation. The cap rate measures what the property earns independent of how it's financed. That's why cap rate is the right number to compare two buildings to each other and the wrong number to evaluate whether a specific financed deal cash-flows for you personally — for that, use cash-on-cash return.

    What counts as a good cap rate?

    A good cap rate depends entirely on the market, asset class, and risk profile. As a rough guide for 2026: stabilized Class A multifamily in major US metros trades around 4.5–5.5%, Class B in secondary metros at 5.5–7%, Class C and small multifamily in tertiary markets at 7–9%, and value-add or distressed properties at 9%+. Single-family rentals typically come in 50–150 basis points wider than comparable-quality multifamily because of higher per-unit management cost and tenant turnover.

    Higher cap rate is not automatically better. Cap rate is yield on the asset, and like any yield, it compensates you for risk: tenant quality, deferred maintenance, market trajectory, lease structure, and the cost of capital. A 9% cap rate in a market with declining population and rising insurance costs may underperform a 5% cap rate in a market with strong job growth and short vacancy times.

    The most useful application is local-comp pricing: pull three to five recently-closed comparable properties, calculate each one's cap rate, and use the median as your discount rate for the property you're underwriting. Bracket the result with the 25th and 75th percentile to show range. That's how appraisers value income property under the income approach and it's directly importable into your own underwriting.

    The three mistakes that inflate every novice calculation

    First, using the seller's pro forma instead of trailing actuals. A seller's pro forma typically assumes 100% occupancy at the highest recent rent, the lowest expense year on record, and zero reserves. That's not what the property has historically produced and not what it will produce next year. Insist on trailing 12-month operating statements and at least two prior years of tax returns for the property before quoting a cap rate. If you must use pro forma, label it as such.

    Second, forgetting reserves. A property without a reserve line item has either deferred its capital expenditures or hidden them in 'repairs' — which is itself a red flag. Roof, HVAC, plumbing risers, parking lot resurfacing, and appliance replacements are all real and recur on predictable schedules. A typical residential reserve runs $250–$400 per unit per year. Leave it out and your NOI is overstated by exactly that amount, which inflates cap rate by 50–100 basis points on a small property.

    Third, not including management. Even if you self-manage today, you should still deduct market-rate property management (typically 8–10% of effective gross income for residential, 3–5% for commercial). The reason: when you sell, the buyer will price the property assuming professional management, so the 'true' NOI you're being compared on is the management-adjusted number. Quoting a cap rate without management makes your deal look better than the market will price it.

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