How to Calculate Cap Rate (With Example & What's a Good Number)

By Ricardo Lau Cooper, Senior Financial Data Analyst · LinkedIn

Cap rate (capitalization rate) is the one number that lets you compare rental deals on a level playing field. It tells you the annual return a property throws off, relative to its price, before financing. This guide walks through the formula, a full worked example, what counts as a good cap rate, and the mistakes that make the number lie to you.

What is cap rate?

Cap rate is the ratio of a property's yearly net operating income to its current value. It's expressed as a percentage, like an interest rate. A 7% cap rate means the property's annual income (after operating costs, before the mortgage) equals 7% of what you paid for it. Investors use it to compare deals quickly: two buildings in different cities, at different prices, can be ranked by the same number.

The cap rate formula

Cap rate = Net Operating Income (NOI) ÷ Property value

Step 1 — Work out Net Operating Income (NOI)

NOI = Gross rental income − Operating expenses

Operating expenses are the costs of running the property: property tax, insurance, maintenance, repairs, property management, and a vacancy allowance. Crucially, NOI excludes the mortgage payment and depreciation — cap rate measures the building's return, not the deal's financing.

Step 2 — A worked example

You're looking at a duplex listed for $250,000. Each unit rents for $1,000 per month. Annual running costs are:

• Property tax: $3,000
• Insurance: $1,200
• Maintenance and repairs: $1,300
• Property management (8% of rent): $1,920
• Vacancy allowance (1 month): $2,000

• Gross rental income: 2 units × $1,000 × 12 = $24,000 per year
• Total operating expenses: $3,000 + $1,200 + $1,300 + $1,920 + $2,000 = $9,420
• NOI: $24,000 − $9,420 = $14,580
• Cap rate: $14,580 ÷ $250,000 = 5.83%

What's a good cap rate?

There's no universal good number — cap rate rises with risk and falls with appreciation potential. As a rough guide for US residential rentals: 3–5% is common in hot coastal markets (low risk, strong appreciation); 5–8% is typical in most mid-size cities; 8–10%+ shows up in higher-risk or slower-appreciation areas. A deal isn't good or bad on cap rate alone — a 4% cap rate in a market that doubles in five years can beat a 9% cap rate where values are flat.

Cap rate vs cash-on-cash return (don't confuse them)

Cap rate ignores the mortgage entirely. Cash-on-cash (CoC) return is the number that includes financing — it's your actual cash return on the cash you put in. The same property can have a 6% cap rate and a 9% CoC return if you finance with cheap debt, or a negative CoC return if the mortgage eats the income. Use cap rate to compare buildings; use CoC return to decide whether a specific deal with your specific loan makes you money.

Common mistakes when calculating cap rate

• Using gross rent instead of NOI — forgetting taxes, insurance, and management.
• Leaving out a vacancy allowance — properties sit empty between tenants.
• Including the mortgage payment in expenses — that's a financing cost, not an operating cost.
• Using the asking price instead of what you'll actually pay or the appraised value.
• Comparing cap rates across different markets without adjusting for risk and appreciation.