Understanding real estate investing can feel confusing at first. New investors often get stuck on basic terms and math. One of the most important concepts you must learn is the cap rate formula. This simple calculation can help you compare properties, understand potential returns, and decide if a deal is worth the money.

In this guide, our team of informational experts explains what the cap rate formula is, how the cap rate formula works, and how to calculate cap rate using easy examples. We keep the language simple, the paragraphs short, and the explanations clear enough for a middle-school student to understand.

Let’s get started.

Table of Contents

What Is the Cap Rate Formula?

The capitalization rate, or cap rate, is a basic formula used in real estate to measure how much income a property can generate compared to its price. Investors use it to understand how quickly they can earn money back from a property.

The cap rate formula looks like this:

Cap Rate = Net Operating Income (NOI) ÷ Property Value

This formula tells you the expected rate of return if you bought a property with cash. In simple words, the cap rate helps you compare profit vs. price.

Cap rate is one of the most used tools in real estate investing. It helps investors:

Compare different properties
Understand how risky an investment might be
Estimate future profits
Decide whether a property is overpriced or underpriced

You will see cap rates used in commercial real estate, rental homes, small apartments, and large apartment complexes.

Why the Cap Rate Formula Matters

The cap rate formula matters because it shows how well a property might perform financially. Many new investors choose properties just because they “seem nice.” But real estate investing isn’t about looks. It’s about numbers.

Using the cap rate formula helps you make smarter decisions because:

It tells you if a property produces good income
It helps you compare one investment to another
It reveals whether the price makes sense
It lets you measure potential risk

A higher cap rate usually means higher risk but higher potential return.
A lower cap rate usually means lower risk but lower return.

Understanding the Parts of the Cap Rate Formula

To understand how to calculate the cap rate formula, you must first understand the two key parts: Net Operating Income and Property Value.

1. Net Operating Income (NOI)

Net Operating Income (NOI) is how much money a property makes after you subtract operating expenses. These are the basic costs to run a property.

NOI includes:

Rent collected
Parking income
Laundry income
Any extra fees or charges

NOI subtracts:

Property taxes
Insurance
Repairs
Maintenance
Property management fees
Utilities paid by the owner
HOA fees
Advertising
Other operating costs

NOI does not include:

Mortgage payments
Income taxes
Depreciation

Think of NOI as the true earnings of a property before paying the loan.

2. Property Value

The second part of the cap rate formula is the value of the property. This can be:

The price the seller is asking
The amount you plan to offer
The estimated market value
The appraised value

Using the actual purchase price gives you the most accurate calculation.

How to Calculate the Cap Rate Formula (Step-by-Step)

Let’s break down how to calculate cap rate in the easiest way possible.

Step 1: Find the NOI

Add up all yearly income from the property.
Subtract all yearly operating expenses.

Example:

Total income: $24,000 per year
Total expenses: $6,000 per year

NOI = $24,000 − $6,000
NOI = $18,000

Step 2: Use the Property Value

Let’s say the property costs $300,000.

Step 3: Use the Cap Rate Formula

Cap Rate = NOI ÷ Property Value
Cap Rate = $18,000 ÷ $300,000
Cap Rate = 0.06 or 6%

This means you would earn a 6% return per year if you bought the property in cash.

What Is a “Good” Cap Rate?

There is no single “good” cap rate because the answer depends on:

The location
The type of property
Market conditions
The risk level

But here are common ranges:

4% to 6%: Low-risk, stable areas (safe but lower income)
6% to 8%: Balanced areas (good mix of income and safety)
8% to 12%: Higher-risk neighborhoods (higher income but more uncertainty)

A good cap rate is one that fits your goals. If you want stable income, a lower cap rate may be fine. If you want bigger returns, you might choose a higher cap rate.

Cap Rate Formula Example (Beginner Friendly)

Let’s imagine you find a rental house.

Yearly income:

Rent: $1,500 per month = $18,000 per year

Yearly expenses:

Taxes: $2,000
Insurance: $1,000
Repairs: $1,500
Management: $2,000
Total expenses = $6,500

NOI = $18,000 − $6,500 = $11,500

Purchase price: $180,000

Now plug into the cap rate formula:

Cap Rate = $11,500 ÷ $180,000
Cap Rate = 0.0638 or 6.38%

This gives you a solid estimate of how the property performs.

Cap Rate vs. Cash-on-Cash Return

Many beginners confuse cap rate with cash-on-cash return, but they are different.

Cap Rate:

Assumes you buy the property with cash
Uses NOI and property value
Does not factor in mortgage payments

Cash-on-Cash Return:

Measures return based on your actual cash invested
Includes mortgage costs
Useful if you use financing

Example:

A property could have a 5% cap rate, but your cash-on-cash return could be 10% if your loan terms are good.

When to Use the Cap Rate Formula

Investors use the cap rate formula in many situations. Here are the most common uses:

1. Comparing Two Properties

If you are looking at two rental houses, the one with a higher cap rate gives a higher return for the price.

2. Checking If the Price Is Fair

If a property has a very low cap rate, it might be overpriced.
If a property has a very high cap rate, it might come with risks.

3. Measuring Risk

Higher cap rate = higher risk.
Lower cap rate = lower risk.

4. Estimating Future Profit

Cap rate tells you roughly how much you may earn each year.

Limitations of the Cap Rate Formula

Even though the cap rate formula is useful, it is not perfect. You should not make decisions based on cap rate alone.

Here are the main limitations:

1. It Does Not Include Mortgage Payments

Cap rate assumes you buy the property with cash. In real life, most people use loans, which change the return.

2. It Ignores Appreciation

Some properties grow in value over time. Cap rate only measures income, not future price increases.

3. It Depends on Accurate Numbers

If the seller gives incorrect expense numbers, your cap rate calculation will be wrong.

4. Markets Change

A cap rate today might not match a cap rate next year.

This is why investors use cap rate as one tool, not the only tool.

Cap Rate Formula for Commercial Properties

In commercial real estate, the cap rate formula works the same way, but the numbers are larger and more complex.

Commercial properties include:

Office buildings
Retail stores
Warehouses
Shopping centers
Large apartment buildings

Investors use cap rates heavily in commercial real estate because they want to:

Compare different buildings quickly
Understand which markets are hot
Estimate long-term profitability

Commercial cap rates vary by city, neighborhood, and type of business.

How Market Trends Affect Cap Rates

Real estate markets change all the time, and these changes affect cap rates.

1. Interest Rates

When interest rates rise, cap rates often go up because investors expect higher returns.

2. Property Demand

If an area becomes popular, prices go up and cap rates go down.

3. Local Economy

Job growth, new businesses, and construction can change cap rates.

Understanding these trends helps investors avoid overpaying.

Cap Rate Formula in Different Real Estate Niches

Different types of properties have different typical cap rates.

Single-Family Homes

Usually have lower cap rates because they are easier to manage and located in stable areas.

Small Multifamily Properties

Duplexes, triplexes, and fourplexes often have higher cap rates.

Large Multifamily Apartments

Cap rates vary based on location and building age.

Vacation Rentals

Cap rates can be unpredictable because income depends on tourism and season.

Using Cap Rate to Evaluate Deals

When you find a property, here’s how to use the cap rate formula to evaluate it:

Collect income and expense data
Calculate the NOI
Divide NOI by the purchase price
Compare the result to similar properties in the area
Decide if the property meets your goals

If a property has:

Strong income
Reasonable expenses
A cap rate that matches your target

…it might be a good investment.

Final Thoughts

The cap rate formula is one of the simplest and most powerful tools in real estate investing. It helps you understand potential income, compare deals, and avoid buying a property that does not make financial sense.

To recap:

Cap Rate = NOI ÷ Property Value
Higher cap rate means higher risk but higher return
Lower cap rate means lower risk but lower return
Cap rate is a starting point, not the final decision
Use it along with other metrics to make smart choices

By mastering the cap rate formula, you can become a more confident investor and make smarter real estate decisions.

Cap Rate Formula: A Complete Guide for Beginners