Cap rate formula: NOI, basis, and the math behind the number

The cap rate formula

The cap rate formula has two parts:

Cap rate = NOI ÷ acquisition basis × 100

• NOI is the property’s annual net operating income.
• Acquisition basis is the capital amount you compare the income with. The standard version uses purchase price. An all-in version adds closing costs and immediate rehab.

If a property produces $24,000 of NOI and costs $400,000, the cap rate is:

$24,000 ÷ $400,000 × 100 = 6.0%

The order of operations matters. Calculate NOI first, then divide by the basis. Do not start with gross rent. Gross rent is not income after vacancy, and it is not income after operating expenses.

Step 1: Build gross scheduled income

Gross scheduled income (GSI) is the rent the property would collect if it were fully occupied for the year, plus other recurring income such as parking, laundry, or pet fees.

For a property rented at $2,600 per month with no other income:

GSI = $2,600 × 12 = $31,200

Use market rent, not a promotional rent or a rent that the seller expects to achieve after renovations that have not happened. If the property is vacant, use a realistic market rent and be explicit about the assumption.

Step 2: Subtract vacancy and credit loss

Vacancy and credit loss accounts for units that sit empty and rent that is not collected. A simple allowance is a percentage of GSI.

At a 5% vacancy allowance:

Vacancy loss = $31,200 × 5% = $1,560

Effective gross income (EGI) = $31,200 − $1,560 = $29,640

Vacancy is not a fixed law of nature. It varies by market, property type, tenant profile, and management quality. A property with a long-term tenant may have low turnover, but it still needs a reserve for the gap between leases. A property in a weak rental market may need a higher allowance.

Step 3: Subtract operating expenses

Operating expenses are the ordinary costs of keeping the property rented and running. Common categories include:

• Property taxes
• Insurance
• Property management
• Maintenance and routine repairs
• Owner-paid utilities
• HOA dues
• Landscaping, pest control, and other recurring services
• Advertising and leasing costs

Two conventions matter.

First, percentage expenses can be calculated from GSI or from EGI. This calculator uses GSI for management, maintenance, and capex percentages. That is a common convention, but it is not the only one. If you compare two models, make sure they use the same base.

Second, reserves are a policy choice. Some investors subtract a capital reserve inside NOI. Others keep reserves below NOI and treat them as a use of cash flow. The conventional broker cap rate often excludes a separate reserve. A conservative underwrite may include one. The calculator lets you turn the reserve on or off.

At an 18% combined percentage rate and $5,400 of fixed expenses:

• Percentage expenses: $31,200 × 18% = $5,616
• Fixed expenses: $5,400
• Operating expenses: $11,016
• NOI = $29,640 − $11,016 = $18,624

What belongs in NOI and what does not

The line between operating expenses and capital items is one of the most common sources of inconsistency.

Included in NOI	Usually excluded from NOI
Property taxes	Mortgage principal and interest
Insurance	Income taxes
Management fees	Depreciation
Routine maintenance and repairs	Major capital improvements
Owner-paid utilities	Leasing commissions for a future lease, depending on convention
HOA dues	Personal expenses of the owner
Advertising and ordinary turnover costs	Acquisition closing costs in the conventional cap rate

A repair restores the property to its previous condition. A capital improvement extends its life or increases its value. The tax rules draw a similar distinction, which is why the IRS Schedule E instructions are useful even if you are not preparing a tax return.

Debt service is excluded because cap rate is an unleveraged measure. If you subtract mortgage payments, you are no longer calculating cap rate. You are calculating cash flow before tax, and the result depends on the loan terms as well as the property.

Step 4: Choose the acquisition basis

The denominator is where two honest investors can disagree.

Purchase price basis is the conventional market-facing cap rate. It answers: what yield does the property produce on the contract price?

All-in basis adds closing costs and immediate rehab. It answers: what yield does the property produce on the total capital committed at acquisition?

Neither is wrong. They answer different questions. If you are comparing a property with a $40,000 roof replacement to one that is turnkey, an all-in basis can make the comparison more honest. If you are comparing your deal to local broker cap rates, purchase price is usually the right convention.

The key is consistency. A 6.5% cap rate on purchase price and a 5.8% cap rate on all-in basis may describe the same deal. Label the basis before you compare.

Reverse cap rate: solving for value

If you know the NOI and the cap rate you require, you can solve for the value the property would support:

Implied value = NOI ÷ target cap rate

Using the same $18,624 of NOI and a 6% target:

$18,624 ÷ 0.06 = $310,400

This is a useful negotiating tool, but it is not an appraisal. The result depends on the NOI and the target cap rate. Small changes in either can produce large changes in value.

At a 7% target, the same NOI supports about $266,057 of value. At a 5.5% target, it supports about $338,618. The property did not change. The market yield did.

Solving for the rent a deal needs

The rent-needed calculation is a little more involved because percentage expenses scale with income. The calculator solves for the gross scheduled income that produces the required NOI after vacancy and percentage expenses, then subtracts other income and converts the result to a monthly figure.

In simplified form:

Required GSI = (Required NOI + fixed expenses) ÷ (1 − vacancy rate − percentage expense rate)

Then:

Monthly rent needed = Required GSI ÷ 12 − other monthly income

For the example, a 6% target on a $300,000 basis requires $18,000 of NOI. With $5,400 of fixed expenses, 5% vacancy, and 18% percentage expenses, the required GSI is about $30,390. The monthly rent needed is about $2,532.

This is not a prediction of market rent. It is the rent that would make the current assumptions hit the target. If market rent is below that number, the deal needs a lower price, lower expenses, a different target, or a different plan.

Common cap rate mistakes

Using gross rent as NOI. Gross rent ignores vacancy and expenses. It is not a cap rate input.

Subtracting the mortgage. Debt service belongs in cash flow, not NOI. A cap rate that includes the loan cannot be compared with a cap rate that does not.

Forgetting property tax reassessment. In many jurisdictions, the assessed value can reset after a sale. Use the expected post-sale tax bill, not the seller’s current bill.

Treating a capital improvement as a repair. A new roof is not the same as a $200 plumbing repair. Decide how you will handle capital costs and be consistent.

Mixing basis conventions. Purchase price and all-in basis are both useful. Mixing them across deals is not.

Ignoring reserves. A property with a 20-year-old roof and HVAC system has future capital needs. If those needs are not reflected in NOI, reflect them in the purchase price, the cash reserve, or a below-NOI reserve line.

Treating the answer as precise. Cap rate is a simple ratio built on estimates. It is a screening and comparison tool, not a guarantee of future performance.

FAQ: cap rate formula questions

The formula is simple. The assumptions are where the work happens. If you cannot explain the source of each income and expense line, the cap rate is not yet decision-ready.

Use the calculator to test the assumptions, then compare the result with local transactions and your own required return. A mathematically correct cap rate can still be a bad deal if the inputs are unrealistic.

Bottom line

Cap rate is NOI divided by acquisition basis. Build NOI from realistic income, a vacancy allowance, and a complete operating expense list. Exclude debt service, income taxes, depreciation, and capital improvements. Label the basis. Then use the result to compare, negotiate, and stress-test the deal.

The math is not the hard part. The discipline is.