How to calculate cap rate (with worked examples) — 2026 guide | TrueCap Blog

The cap rate formula

Cap rate = Annual NOI ÷ Purchase price

Two inputs. Get either one wrong and the cap rate lies to you. The formula is fine; the discipline is in how you compute NOI.

How to compute NOI correctly (5 steps)

NOI is net operating income — what the property earns after operating expenses but before debt service. Skipping any of the five steps below is the #1 reason cap rates look better on paper than they perform.

Step 1: Gross potential rent

Monthly market rent × 12. Use the actual lease rent if the property is currently rented; use comparable-property market rent if vacant.

Step 2: Subtract vacancy allowance

Typical 5-8% of gross rents. Even in a hot market, factor in turnover periods, the 30 days you might need to refresh between tenants, and a lease that ends mid-month. A property with a 12-year tenant is still going to turn over eventually.

Step 3: Subtract operating expenses

The full list — easy to skip half of these:

Property taxes (use the current assessment; some markets reassess at sale).
Insurance(landlord policy, not homeowner's).
Property management (8-10% of gross rent; include even if self-managing — your time has a real cost).
Maintenance reserve (1-1.5% of property value annually).
CapEx reserve (1% of property value annually for roof, HVAC, water heater, kitchen renovations, etc.).
Utilities you pay (water, trash, sewer in many areas; everything for multi-family common areas).
HOA fees, lawn/snow service, pest control.

NOT in operating expenses: mortgage principal, mortgage interest, depreciation, or income tax. These are financing and tax items, not operating costs.

Step 4: Calculate NOI

What's left after step 2 and step 3. This is the property's true earning power.

Step 5: Divide by purchase price

NOI ÷ purchase price = cap rate. Multiply by 100 to express as a percentage.

Worked example #1: a good deal

$300K single-family in Tier 2 city, asking $300K, rents at $2,400/mo.

Gross rent: $2,400 × 12 = $28,800
Vacancy (6%): −$1,728
Effective gross income: $27,072
Property tax: −$3,600
Insurance: −$1,200
Management (8%): −$2,166
Maintenance (1.2%): −$3,600
CapEx reserve (1%): −$3,000
Utilities + HOA: −$600
NOI: $27,072 − $14,166 = $12,906
Cap rate: $12,906 ÷ $300,000 = 4.3%

That cap rate is low for a Tier 2 city — the seller's ask is rich for the rents. Maybe a great cash-on-cash deal with high leverage, but the property itself isn't a yield machine.

Worked example #2: the “9% cap” that isn't

Same property, but the broker tells you it's a “9% cap.”

Gross rent: $28,800
Property tax: −$3,600
Insurance: −$1,200
Broker's “NOI”: $28,800 − $4,800 = $24,000
Broker's cap rate: $24,000 ÷ $300,000 = 8%

The broker skipped vacancy, management, maintenance, CapEx, and utilities. The cap rate looks like 8% but the real one is 4.3%. This is the most common cap rate manipulation in broker pro formas — be ruthless about adding back every expense before trusting the number.

Worked example #3: cash purchase same property

Cap rate is identical regardless of financing — that's the whole point of using NOI (pre-debt service). A cash buyer of the property in example #1 gets the same 4.3% cap rate as a buyer using 75% leverage. Their cash-on-cash returns are very different; their cap rates are the same.

This is why cap rate is the metric to use when comparing properties, and cash-on-cash is the metric to use when comparing investments(since financing is part of an investment decision but not part of a property's intrinsic yield).

When cap rate is the wrong metric

Cap rate breaks down in three cases:

Heavy rehab properties. A vacant gut-rehab has $0 NOI today. Cap rate at purchase is 0% regardless of upside. Use ARV cap rate (NOI after rehab ÷ all-in cost) instead.
Short-term rentals.STR “cap rates” reported in listings often use unrealistically high projected revenue. Underwrite STRs on cash flow with full OpEx buildup instead.
House hacks.When you live in one unit, the “cap rate” calculation is meaningless — use net housing cost vs. renting instead. Full guide here.

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FAQ

What's the cap rate formula in one line?

Cap rate = annual NOI ÷ purchase price (or current market value). NOI means net operating income — gross rents minus all operating expenses (taxes, insurance, maintenance, management, vacancy allowance, utilities you pay), but BEFORE mortgage payment. Mortgage is financing cost, not operating cost — never subtract it from NOI when computing cap rate.

What counts as an operating expense in NOI?

Property taxes, insurance, property management (typically 8-10% of rent), maintenance reserve (typically 1-1.5% of property value/year), CapEx reserve (typically 1% of property value/year), vacancy allowance (typically 5-8% of gross rents), utilities you pay (water, trash, sewer in many areas), HOA fees, and lawn/snow service. NOT: mortgage principal, mortgage interest, depreciation, or income tax.

What's a good cap rate in 2026?

Highly market-dependent. In Class A markets like Austin, Nashville, or Raleigh, 4-5% is competitive on stabilized properties. In Tier 2 / 3 markets like Cleveland, Memphis, or Birmingham, 7-9% is achievable but you take on more vacancy and rougher tenant pools. Above 10% usually means either heavy rehab risk, weak market fundamentals, or unrealistic NOI assumptions. Below 4% usually means you're paying for appreciation, not yield. There's no universal 'good' cap rate — it depends on what risk and market you're in.

Should I use purchase price or market value in the denominator?

Both are used in different contexts. Cap rate at purchase uses purchase price — useful for analyzing a specific deal. Cap rate at current market value (sometimes called 'yield on cost' when using purchase price) is useful for comparing across properties or tracking your portfolio. When commercial appraisers talk about cap rate, they typically mean market-value cap rate. When investors talk about a deal they bought, they usually mean purchase-price cap rate.

Is cap rate higher always better?

No. A 12% cap rate in a market where 7% is normal usually means something is wrong: deferred maintenance, vacancy risk you haven't priced in, neighborhood declining, or overstated rents. A 4% cap rate in a high-growth market where appreciation has averaged 7-9% annually can be a great deal. Cap rate is a starting filter, not a final answer.

What's the difference between cap rate and cash-on-cash return?

Cap rate ignores financing entirely (NOI ÷ price). Cash-on-cash includes the mortgage payment ((NOI − annual debt service) ÷ cash invested). So cap rate tells you the property's intrinsic yield, cash-on-cash tells you the return on the dollars you actually put in. A property with 6% cap rate can produce 12-15% cash-on-cash with 75% leverage when rates are below the cap rate — that spread is the 'positive leverage' that makes real estate work.