What Is a Cap Rate? Formula, NOI Calculation, and Examples

A cap rate, short for capitalization rate, is the annual return an income-producing property would generate if you bought it entirely with cash. You calculate it by dividing the property’s net operating income by its current market value, then multiplying by 100 to express the result as a percentage.¹ Because the formula ignores financing, it lets you compare properties on equal footing regardless of how any particular buyer would fund the purchase.²

A property producing $75,000 in net operating income at a $1,000,000 market value has a cap rate of 7.5%. That figure is your annual yield before loan payments, tax benefits, or appreciation come into play.² The math is easy. Getting the two inputs right is where the actual work sits.

How to Calculate Net Operating Income

Net operating income, or NOI, is total property revenue minus operating expenses for the year. Revenue starts with gross rental income and includes anything else the property earns, such as parking fees or coin-operated laundry.¹ From that total, subtract the costs of keeping the building functional and occupied.

Typical operating expenses include property taxes and insurance, which are often the largest fixed costs; routine maintenance items like landscaping, plumbing calls, and appliance replacements; and property management fees, which commonly run between 4% and 12% of collected rent depending on property type and market. You also deduct a vacancy allowance, a projection of the income lost when units sit empty between tenants. A 5% vacancy allowance on a property collecting $200,000 in annual rent reduces effective revenue by $10,000.

What to Leave Out of NOI

Some costs are deliberately excluded because they reflect the owner’s financial situation rather than the property’s operating performance. Mortgage principal and interest stay out. So do capital expenditures like a full roof replacement or a major renovation. Depreciation, the accounting deduction the IRS allows over the life of a building, is also excluded.³ These exclusions are what make the cap rate an unleveraged metric. Two investors looking at the same building will arrive at the same cap rate no matter how differently they’d finance it.

Choosing the Right Property Value

The denominator is the property’s current market value. For a property that just sold, the purchase price works. For a property you’ve held for years, you need an updated figure. A stale or inflated value will distort everything. A property worth $1,200,000 today that you still carry at your $900,000 purchase price from a decade ago will produce an artificially high cap rate that the market doesn’t actually support.

A Worked Example

Suppose you’re evaluating a small apartment building listed at $1,400,000. The property collects $156,000 per year in rent and $4,000 from a handful of parking spaces, bringing gross revenue to $160,000. Subtract $32,000 in property taxes, $8,000 in insurance, $12,000 in maintenance, $14,000 in management fees, and an $8,000 vacancy allowance. NOI comes to $86,000. Divide $86,000 by $1,400,000, multiply by 100, and the cap rate is roughly 6.1%.²

That single number lets you set this building side by side with a retail strip center or a warehouse in the same market without worrying about loan terms or down payment sizes.

What a Higher Cap Rate Really Means

This is where new investors often trip up. A 9% cap rate looks more attractive than a 5% cap rate on paper, but cap rates also measure risk. Properties in stable, high-demand locations command lower cap rates because the income stream is more predictable and vacancies are rare. Properties in weaker markets or with deferred maintenance offer higher cap rates precisely because buyers need a bigger return to accept the additional risk.²

Think of it like bond yields. A U.S. Treasury bond pays less than a corporate junk bond, but nobody would call the Treasury a worse investment. The lower yield reflects lower risk. A 4.5% cap rate on a fully leased apartment building in a major metro is not a problem to solve. It’s the market pricing in the stability of that income.

What Drives Cap Rates

Location and Market Demand

Geography is the single biggest factor. In dense urban centers with strong employment bases and limited supply, investors accept lower cap rates because the risk of prolonged vacancy is small. CBRE’s H2 2025 survey found Class A multifamily cap rates of 4.5% to 5% in New York City and San Francisco, and 4.75% to 5.5% in Los Angeles.⁴ Secondary and rural markets, where turnover is higher and demand fluctuates more, push cap rates into the 7% to 10% range.

Property Type and Condition

Cap rates vary across asset classes. As of Q4 2025, national average cap rates for multifamily properties sat at about 6.1%, while industrial properties averaged around 7.2%.² Class A buildings with modern finishes and creditworthy tenants trade at lower cap rates than Class C buildings that need more active management and carry higher turnover costs.

Interest Rates

When borrowing costs rise, cap rates tend to follow. Higher rates make financing more expensive, which reduces what buyers can pay and pushes cap rates upward. The aggressive rate hikes of 2022 through 2024 caused noticeable cap rate expansion across most property types. With the Federal Reserve signaling further rate cuts in 2026, many market participants expect cap rates to stabilize or compress slightly as financing costs ease.²

Compression and Expansion

When cap rates fall across a market, that’s compression. Property values are rising faster than incomes. The decade from 2010 to 2021 saw dramatic compression, with multifamily properties that traded at 7% to 8% cap rates in 2010 selling at 4% to 5% by 2021 in many markets. Expansion is the reverse. Cap rates rose from 2022 through 2024 as interest rate increases pushed property values down even when operating income held steady. Knowing which phase your market is in helps calibrate expectations for both entry yield and eventual resale value.

Cap Rate and Property Value Move in Opposite Directions

When income stays constant, cap rate and value are inversely related. A property generating $100,000 in NOI that sells for $1,000,000 has a 10% cap rate. If the market pushes that same property’s value to $1,250,000 while income stays flat, the cap rate drops to 8%. The building didn’t get worse. The market just decided it was willing to accept a lower yield in exchange for the stability or appreciation potential the property offers.

This relationship works in reverse as a valuation tool. If the market cap rate for comparable properties is 6%, and a building produces $90,000 in NOI, you can estimate its value at roughly $1,500,000 by dividing NOI by the cap rate. Brokers and appraisers price commercial real estate this way constantly.

Actual vs. Pro Forma Cap Rates

An actual cap rate uses the property’s current, verified income and expenses. A pro forma cap rate uses projected numbers, often assuming the owner will raise rents, reduce vacancies, or cut operating costs after taking over. Sellers quote pro forma cap rates because they make the deal look better. Experienced buyers run both versions and treat the gap between them as a measure of execution risk.

When a marketing package shows a 7.5% pro forma cap rate, ask for the trailing 12 months of actual financials. If the actual cap rate comes in at 5.8%, that 1.7-point spread is income the property hasn’t earned yet and might never earn. You need confidence in your ability to close that gap before paying a price based on the projection.²

Entry and Exit Cap Rates

Your entry cap rate is the one you calculate at purchase. Your exit cap rate is the one the market applies when you sell. These two numbers drive a large share of total return. If you buy at a 6% cap rate and sell five years later when the market has compressed to 5%, the property’s value increased even if NOI stayed flat. If the market expanded to 7% instead, you lost value.

Conservative underwriting assumes a higher exit cap rate than the entry rate. Buying at a 5% cap and modeling the sale at 5.5% or 6% builds in a cushion for market uncertainty. Many institutional investors won’t approve a deal unless the model still works with 50 to 100 basis points of exit cap rate expansion baked in.

Where Cap Rate Falls Short

Cap rate is a snapshot, and snapshots miss things that unfold over time. It doesn’t capture appreciation, which is often the largest component of total return in strong markets. It ignores financing benefits like mortgage interest deductions and the leverage effect on equity returns. And it assumes the current NOI will continue indefinitely, which is rarely true for properties undergoing repositioning or significant capital improvements.

For value-add properties, where the plan involves renovating units and raising rents over two to three years, the cap rate at purchase tells you almost nothing useful. The current income reflects the property’s old condition, and the purchase price reflects what the buyer expects it to become. Using the going-in cap rate to compare a stabilized Class A building against a distressed value-add project is comparing two fundamentally different bets.²

Cap rate also says nothing about physical condition, tenant quality, or upcoming capital needs. A building with a 7% cap rate and a roof that needs replacing next year is a very different proposition from one with a 7% cap rate and a brand-new roof. Pair every cap rate calculation with a thorough inspection, a rent roll review, and at least a rough capital expenditure forecast before making an offer.

1
PNC Insights. Capitalization Rate: What It Is and How It’s Calculated
2
J.P. Morgan. The Role of Cap Rates in Real Estate
3
Internal Revenue Service. Publication 946 (2024), How To Depreciate Property
4
CBRE. US Cap Rate Survey H2 2025