Cap Rate Formula: How to Calculate NOI and Cap Rate Step by Step

The cap rate formula is:

Cap rate = net operating income / purchase price

The formula takes seconds. Building an honest net operating income takes the work, and most cap rate disagreements between buyers and sellers are disagreements about NOI. Here is each line in order, then three worked examples.

Step 1: gross scheduled income

Monthly rent times twelve for every unit, plus other income: parking, laundry, storage, pet rent, utility reimbursements. This is the income at full occupancy.

Use the rent the property actually commands. For a vacant unit, use market rent supported by comparable listings, not the seller’s aspiration.

Step 2: vacancy and credit loss

Subtract an allowance for empty months and unpaid rent. 5% is standard for stable long-term rentals. 8 to 10% for student housing, lower-priced units and markets with high turnover. Even a property that has been full for years gets a vacancy allowance, because it will turn over eventually.

Gross scheduled income minus vacancy is effective gross income.

Step 3: operating expenses

Everything it costs to run the property. The list:

• Property taxes, at the rate you will pay after purchase. Many counties reassess on sale. The seller’s bill can understate yours by 30% or more.
• Insurance. A landlord policy, plus flood, wind or earthquake where applicable.
• HOA or condo dues.
• Maintenance and repairs. 5 to 10% of collected income, higher for older buildings.
• Capital reserves. Roof, HVAC, water heater, appliances, flooring. Another 5 to 10% set aside so one bad year does not erase three good ones.
• Property management. 8 to 10% of collected income for long-term rentals. Include it even if you will self-manage, because an appraiser and the next buyer will.
• Owner-paid utilities, landscaping, snow removal, pest control, common-area electricity.
• Advertising and leasing costs, legal, accounting, licenses and inspections.

Step 4: what stays out

Mortgage payments. NOI is before debt service by definition.

Depreciation and income taxes. Those are on your tax return, not the property’s operating statement.

Capital improvements that add value, such as an addition or a full renovation. Those are investments, not operating costs. Routine replacement of worn components is what the reserve covers.

Step 5: divide

Effective gross income minus operating expenses is net operating income. NOI divided by price is the cap rate. The calculator runs every step and shows the intermediate lines.

Example 1: a single-family rental

$300,000 house renting for $2,500. Taxes $3,600, insurance $1,500. Standard allowances.

Line	Amount
Gross scheduled income	$30,000
Vacancy at 5%	($1,500)
Effective gross income	$28,500
Taxes	($3,600)
Insurance	($1,500)
Maintenance, reserves, management at 18%	($5,130)
Net operating income	$18,270
Cap rate on $300,000	6.1%

The expense ratio is 36% of collected income, which is typical for a single-family rental with taxes near 1.2% of value.

Example 2: a duplex

$380,000 duplex, two units at $1,650, so $3,300 a month. Taxes $5,200, insurance $2,200. Same allowances.

Gross scheduled income is $39,600. After 5% vacancy, $37,620. Taxes and insurance are $7,400, and 18% of collected income is $6,772. Operating expenses total $14,172 and NOI is $23,448. Cap rate: 6.2%.

The duplex costs 27% more than the house and produces 28% more NOI, so the cap rates are almost identical. That is the comparison cap rate exists to make. Whether the duplex’s extra turnover and shared systems are worth it is a separate judgment.

Example 3: the broker’s pro forma

Same $300,000 house. The listing’s pro forma shows $30,000 of rent with no vacancy, taxes of $3,600, insurance of $1,500, and no line for maintenance, reserves or management. NOI: $24,900. Advertised cap rate: 8.3%.

The honest cap rate is 6.1%. The pro forma added 2.2 points by leaving out three expense lines and vacancy. At a 6% market cap rate, that inflated NOI implies a value of $415,000 for a property worth about $304,500.

This is the most common cap rate error in practice, and it is not always deliberate. Owners who self-manage and have had no vacancies genuinely experience a higher NOI. A buyer should still underwrite the property as if they will pay for management and have turnover, because they will.

Mistakes that inflate a cap rate

• No vacancy allowance.
• No management, because the owner self-manages.
• No capital reserves, because nothing broke this year.
• Seller’s tax bill instead of the reassessed one.
• Rent from the listing instead of from comparable leases.
• Dividing gross rent by price and calling it a cap rate.

Each of these adds a fraction of a point to two points. Stacked, they turn a 5% property into an 8% listing.

Going-in versus market cap rate

Cap rate on your purchase price is the going-in cap rate. Cap rate on current market value is the market cap rate. They are the same on the day you buy at market and diverge afterward. An owner who bought at $250,000 five years ago and now has $18,270 of NOI on a property worth $300,000 has a 7.3% going-in cap rate and a 6.1% market cap rate. The second is what a buyer sees.

What to do with the result

Compare the cap rate to recent sales of similar property in the same submarket, not to a national figure. The good cap rate guide explains the bands, and the cap rate pages show the rent and NOI behind each rate from 3% to 12%.