Real Estate Deal Analysis & Advice

How to Calculate Cap Rate (& Where Many People Get It Wrong)

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One of the most common questions I get when discussing real estate investing is how I evaluate properties to determine the investment potential. While there are many factors that come into play, the one criteria that is critical to get right in the evaluation is the capitalization rate, or cap rate for short.

What’s the Definition of Capitalization Rate?

The easiest way to understand cap rate is the expected return (as a percent) an investment will generate based on the net operating income (NOI) of the asset.

Cap rate is applied against the market value of the property to determine NOI. For example, a property worth $1 million and being sold at a cap rate of 10 would be expected to generate annual NOI of $100K.

$1,000,000 x .10 = $100,000

Mind you, you are not going to find a property with that kind of cap rate these days. This illustration is simply for easier math. Also, cap rate does not include debt service. If you are financing the acquisition, that gets factored in later.

First, let’s talk about some expectations when it comes to cap rates and how to determine what cap rate to use and when.

What Cap Rate to Use

Some variables that come into play include the regional location of the property (Philadelphia, N.Y., Chicago, L.A., etc.), the class of property (Class A, B, C, or D), type of property (multifamily, office, retail, industrial, etc.), market conditions (supply, demand, interest rates), and geographic location (city, suburbs). We rely on a combination of industry research, our local market evaluation and deal marketing, and transactions.

Below is a table of some cap rate expectations based on the current market for multifamily properties. It’s not based on anything more than what I am seeing and the N.Y./L.A. numbers are for comparison only:

The simplest way to define different classes of properties (A, B, C) is:

  • Class A: Brand new construction and/or prime location.
  • Class B: Buildings that are no longer new and are in need of light renovation (facade, landscaping, common area upgrades) but overall are in well-maintained functional condition and a good location.
  • Class C: Older buildings in need of functional and/or infrastructure improvements, with a less ideal location.

Value-add and distressed properties are those in some form of disrepair, outdated, or generally mismanaged.

You can see a big difference in return expectations between the Philadelphia market and coastal cities, as well as between the class of properties. This is why so many investors in these areas are looking to other markets for larger returns.

The numbers I use are expectations based on TRUE cap rates. We’ll talk about how so many deals are misrepresented.

How to Use the Cap Rate

Now, let’s look at some of the ways to use cap rate to determine value when buying and selling. From there, we’ll get into factors that determine the appropriate cap rate to use and then discuss some of the tricks used by brokers and agents to hide the true cap rate.

The general rule of thumb is that you want to buy at a higher cap rate and sell at a lower rate. You’ll see why in a minute.

Suppose you want to invest in the Philly area and are interested in long-term equity appreciation with some positive cash flow, too. We’ll assume that you have $100K to invest and will use financing to acquire a property for around $400K.

Related: 6 Advantages of Buying in an Expensive, Low Cap Rate Market

A 25 percent down payment is standard on investment real estate. Note that there are closing costs, etc., that I am not including to make the math easier.

Let's look at what kind of net income you can expect between a Class A and C property. Again, we are not including paying the loan here.

Class A: $400K x .055 (5.5 CR) = $22,000
Class C: $400K x .0675 (6.75 CR) = $27,000

Now, let’s look at it the other way. Suppose you wanted to buy an investment property that can generate $50K a year in net income. To determine what you can expect to pay, we divide the number by the cap rate. Using the same examples we get the following:

Class A: $50K / .055 = $909,090
Class C: $50K / .0675 = $740,740

Another way to use a cap rate is in figuring out how much value you can increase a property by through increased rents or reducing expenses. Both will result in an increased NOI.

Suppose the property you are evaluating above has the potential to generate another $5K a year through increased rents or reduced expenses. Again using the same example:

Class A: $55K / .055 = $1,000,000
Class C: $55K / .0675 = $814,814

This is what we call value-add, meaning that there is potential to increase the value in a property. This may be short-term if there are minor changes to be made or longer-term if it will take some time to implement.

In the above examples, you can really start to see the power of using the cap rate in the analyses. You bought a property for just over $900K, increased the NOI by $5K/year and have now increased the value to $1M!

The reason this happens is simple. The market dictates the cap rate, and the cap rate is based on the NOI. In this case, the cap rate at purchase and sale remained the same, but the NOI was raised by 10 percent.

There is a way to re-position the property by moving it from one class to another through upgrades and improvements. This would result in changing the value by using a lower cap rate.

One thing to make clear, though, is that a cap rate is generally applied to commercial properties, which in the view of lenders are properties that are either zoned commercial or residential with more than four units. This is very important, because if you are financing a deal, then it has to appraise. Properties with four units or less are appraised first based on comparable sales and then income.

Where So Many Investors Go Wrong

Even though it should be easy to determine the value by using a cap rate, many new investors don't factor in all the expenses or dig deep enough into the numbers to uncover the true value. This is often because a seller and his or her agent/broker don't give the full picture of the performance of a property. That is to say they either don't include all of the expenses, base the projected rents off pie-in-the-sky numbers, or do a combination of both.


The first red flag is when the term pro forma is used as a basis of the stated cap rate. This means that the rents and expenses are projection-based and in most cases absolute best-case scenario. A more accurate way to determine the actual performance is by getting a trailing 12 months (T12) profit and loss statement. Many agents will only send you a spreadsheet with actual numbers for income, taxes, insurance, and maybe utilities. The rest is up to you to determine.

I will say that, the bigger the deal size, the better information you will or should get.

There are cases where a pro forma is the only way to value a property, like for new construction, and many good brokers are honest with their numbers. But it requires much more due diligence to validate. You will also base purchase decisions on your own pro forma, which is what you will create to determine the value as you see it.

Let’s look at an example.

Say you are looking at a 10-unit property that is being sold for $1 million at a 6 percent cap rate. The net income should be $60K a year ($1,000,000 x .06 = $60,000). The offering docs state that the pro forma rents are $900 a month per unit.

That means $9K a month and $108K a year. So far, so good. The pro forma expenses total $48K, which gets us to the $60K NOI.

Now, let’s say this property actually is generating an average of $800 a month in rent, and the expenses are 45 percent of the income. This brings us to $750 per unit x 10 units = $7.5K per month and $90K per year. Subtract 45 percent in expenses, and you get $49,500.

At the same cap rate, the property is actually worth $825K ($49,500 / .06 = $825,000). You, my friend, just overpaid by $175K!

This happens when the offer is based off projected numbers provided by the seller, and the buyer doesn’t have the know-how or experience to perform proper due diligence.

I see this each and every day!

Here is the minimum list of expenses you should expect to see in an offering—and also dive in deep to validate in your analysis:

  • Property taxes (normally accurate, because they are public record)
  • Insurance
  • Utilities paid by owner
  • Maintenance and repairs (1-3% of value per year, depending on class)
  • Landscaping and snow removal
  • Municipal licensing
  • Property management (5-7% of gross rents)
  • Vacancy (5%)
  • Variable expenses

If you get these right, then you will be much closer to actual costs. Still, this is heavily dependent on the complete and accurate records of the owner/manager of the property.

Let’s Run Some Numbers!

Let’s look at an actual listing that came into my inbox recently.

First the description:

“Fully-leased quadplex in the booming Brewerytown submarket of Philadelphia, Penn., on its main commercial corridor, Girard Avenue. This dramatic corner property features four units fully leased/occupied, generating strong positive cash flow from day one.

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“A savvy investor could cosmetically enhance units 2/3/4 with subtle improvements to drive rent increases and boost the performance of the building in no time. These units lease quickly and are in high demand…”

Here are the numbers pulled directly from the listing. Asking price is $764,999 at a 7.5 cap rate, wonderful! The total rent claim is $65,400, with a net income of $57,524.

Wow! Could it really be operating at a 12 percent expense ratio?

No way!

These numbers came from the agent and seller only including obvious expenses, like property taxes and insurance. What I can tell you is that even brand new construction will operate at a 30 to 35 percent expense ratio, and that's just in the first couple of years.

The rule of thumb is to assume that expenses are 40 to 50 percent of income. This would become clear as a full and detailed analysis was done during underwriting.

If we now factor in a conservative expense number like 35 percent, we get an actual NOI of $42,510. With a sale price of $765K, we are now looking at a real cap rate of 5.5 (NOI / asking price).

Going back to our cap rate expectations, and what we know of its location, we can cross this one off the list of properties to pursue.

Related: 5 of Your Most Burning Questions About Cap Rate, NOI, & More—Answered

The crazy thing about this deal is that, because it is four units, it will be appraised based on sale comps. The market for these types of properties has been out of control, so it would most likely appraise for the sale price.

All of the above is what I call paper napkin analysis, which is only useful for a first level filter when looking at properties. We use tools like the BiggerPockets Buy and Hold Calculator to include all expense categories and numbers that are based on detailed analysis and years of experience—but only after a property passes a sniff test. Unfortunately, a hot real estate market drives many reality TV-watchers and folks with more money than sense to overpay.


There are many other ways to use the cap rate in evaluating properties, so I would suggest going on Zillow or LoopNet and finding a few investment properties to test the math. It becomes much easier the more you analyze, and you will eventually be able to quickly determine which deals are worth looking into.

It’s also worth noting that the bigger the deal and higher the class of property, the more likely you will get actual reports of income and expenses. Larger and higher class projects are more likely to be professionally managed, with all aspects of the asset performance tracked and reported by the management company to the owner. This helps to get a more accurate cap rate to gauge.

If you only get a one-page spreadsheet, or just an offering document from the broker, then you will most likely not be able to get a good picture of the financial performance of the property. This is where a savvy investor will tap into resources with hands-on experience in the immediate market and comparable asset classes to help develop a framework of realistic numbers.

Learning how a cap rate is calculated will help you go a long way in evaluating investment-grade properties. It is even more important to be thorough in your analysis and realize that it’s just one tool to master.

Here are the formulas we discussed, so you can practice:

  • NOI / Cap Rate = Property Value
  • Property Value x Cap Rate = NOI
  • NOI / Property Value = Cap Rate

Happy investing!

Questions about cap rate?

Ask me in the comment section below!

Sergio is a real estate investor specializing in syndication investing for beginner to advanced investors. Although he has primarily invested in the greater Philadelphia market, he is expanding int...
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    David Roberts from Brownstown, Michigan
    Replied about 1 month ago
    How do you factor in cap ex? Is it part od the expense ratio, let's say expenses are 50%, does that include cap ex? What do u allocate for cap ex?
    Sergio Altomare Rental Property Investor from Greater Philadelphia
    Replied about 1 month ago
    In addition to what Ken said, your cap ex costs will be factored in when underwriting the deal and will become part of your overall return and IRR.
    Kenneth Blacow from Peachtree City, GA
    Replied about 1 month ago
    David, when using cap rate to decide on the purchase price cap ex expense is not evaluated, this is straight income after operating expenses divided by your cap rate. You would add capital expenditures to your model below this line.
    Colin March Rental Property Investor from Portland, ME
    Replied about 1 month ago
    Kenneth, I'd argue that replacement reserves absolutely would be added to the expenses. If you buy a property with a new $5000 HVAC that has a 10 year useful life, I'd run that at $500/year as an expense when underwriting the net income or cash on cash return of a property.
    Sergio Altomare Rental Property Investor from Greater Philadelphia
    Replied about 1 month ago
    Where do you stop with this approach? If I underwrite and include depreciation as an expense then all of my properties would be in the red. We budget for cap ex, but not as expenses.
    Colin March Rental Property Investor from Portland, ME
    Replied 29 days ago
    What is the difference between budgeting for capex and including replacement reserves as an expense? That is the same thing in my mind. If you are arguing that depreciation of capital goods is not a true expense, check out some of Warren Buffett's writing on this topic. Another way to look at it would not be cap rate and just do a long term cash flow model with IRR as your output and include the period large expense items and that will be an accurate way to analyze your return. Remember, investors have many asset classes to consider and ultimately all that matters is ROE so cap rate is actually and output and not an input for your analysis.
    Immanuel Sibero from Carrollton, TX
    Replied 29 days ago
    Random thoughts about cap rate: - Cap rate is defined as NOI/Purchase(Value). NOI is defined as Revenues – Operating Expense. Any expenditures that are “operating” in nature do not belong in NOI (i.e. that’s why it’s called Net “OPERATING” Income). Presumably “operating” in this case means “keeping the property in operating conditions so as to generate revenues”. The expenditure of fixing a stopped up toilet is “operating” in nature because a stopped up toilet would cause the property to cease to operate. The expenditure of a new roof is NOT “operating” in nature because it can be deferred and when it is deferred, the property can still operate, therefore a new roof does not belong in NOI. The IRS has a very similar view to this. The point here is if an expenditure belongs in NOI then it belongs in cap rate, if it doesn’t then it doesn’t belong in cap rate. I call this view the purist, theoretical view of cap rate. But below are some of the real world views of cap rate. - As part of calculating DSC, banks usually require “replacement reserves” to be set up and to be included in NOI even though replacement reserves are NOT “operating” expenditures (i.e. without replacement reserves the property can still operate just fine). As a result, the calculated cap rate is really an “adjusted” cap rate (cap rate with replacement reserve). - Some investors see cap rate as a performance measure (WRONG!) and insist on including CapEx in NOI because if CapEx was not included then the cap rate would not reflect reality. Again CapEx is NOT “operating” in nature so doesn’t belong in NOI. As previously mentioned in this thread, yes I think “replacement reserves” are the same as CapEx, but some investors consider them different. - Still, there are other investors who see cap rate as a performance measure (again WRONG!) and insist on including loan payments in NOI. They even have a specific name for this “Levered” Cap Rate (i.e. as opposed to “Unlevered” cap rate). I’m a purist, so my view of cap rate is represented by the first one in the above list. When the formula definition calls for “operating” then anything that’s NOT operating in nature does NOT belong (but of course if the bank wants “replacement reserves” in NOI to fund 75% of my project, what am I not to oblige). I find it challenging to the point where I try to avoid when someone at investor meetups or socials brings up “cap rate” because then I’m always tempted to ask them - What do you mean by cap rate? Cap rate adjusted for replacement reserve? Cap rate adjusted for capex? Levered cap rate? Unlevered cap rate? Which one? As Sergio puts it, “Where do you stop?” For a metric of limited use, cap rate is widely misunderstood, misused. Cheers… Immanuel
    Immanuel Sibero from Carrollton, TX
    Replied 29 days ago
    Arrrggghh! Sorry, that didn't work well... That will be the last time I'm commenting on an article/blog... what a horrible format, it just completely destroyed readability. The comment editor on articles/blog posts does not work as well as it does in the forums.
    Sergio Altomare Rental Property Investor from Greater Philadelphia
    Replied 28 days ago
    Very well said, Immanuel, regardless of the formatting. I think we are also venturing from analysis to operations budgeting, which will include accounting more for CapEx and reserves. Our investment model includes an exit at year 5-7, but we analyze the deals including a capex budget for anything that can or will need to be replaced within that hold period, or more than likely up front. If I am budgeting long-term then I would either plug the capex expenditure in the year I expect to incur it, or maybe include it as a line item as Colin said. Great discussion! Thanks
    Sergio Altomare Rental Property Investor from Greater Philadelphia
    Replied about 1 month ago
    Thank you sir!
    Lucia Rushton Realtor from Dallas, TX
    Replied about 1 month ago
    Great piece Sergio!
    Sergio Altomare Rental Property Investor from Greater Philadelphia
    Replied about 1 month ago
    Thanks Lucia!
    Michael P. Lindekugel Real Estate Broker from Seattle, WA
    Replied about 1 month ago
    As someone that taught matriculated finance and accounting I am not fan of that definition. I think it is misleading. All ROI calculations involve cash flows. Capitalization rate has nothing to do with cash flow. It measures amount of Net Operating Income as a function of price whether the calculation is performed on historical financial statements for forward looking or pro forma financial statements. Capitalization rate has nothing to do with ROI. Capitalization rate is better thrown in with other non ROI common accounting formula measurements such as profit margin. Capitalization rate is index only applicable to the other data points in the study. You can have a capitalization rate of 4% in Seattle at $400k/unit whereas another city with same capitalization rate could be $50k/unit. As Sergio pointed out real property has lots of subjective qualitative components that cannot be converted quantitative data easily. The number one problem with capitalization rate is many brokers and investors falsely believe that it is a ROI calculation. There are many accounting items and tax treatment items below NOI to calculate Net Income and cash flow needed to perform any ROI calculation. It is possible to have a high capitalization rate and a low IRR. Without calculating the IRR the broker and investor are relying on a false positive Go signal to invest. And, it is possible to have the reverse which is an opportunity when others fail to recognize the investment opportunity from lack skill set which very common. I am not saying capitalization rate is not important. It is only one metric in the toolbox. All the financial metrics should be reviewed.
    Sergio Altomare Rental Property Investor from Greater Philadelphia
    Replied about 1 month ago
    Well said Michael. Cap Rate is just a tool used for comparison purposes only. Thanks
    Joseph J DeStefano
    Replied about 1 month ago
    Great Article Sergio! I think these formulas are a great tool. I find it that our market (Philly) can be very tough to analyze from one neighborhood too the next but using the numbers makes it somewhat easier.
    Sergio Altomare Rental Property Investor from Greater Philadelphia
    Replied about 1 month ago
    Thanks Joe. Philly is definitely a tough market to value, especially when looking at smaller multifamily. You can only value those based on your investment expectations, but against sale comps.
    Aaron Bryson from Global
    Replied about 1 month ago
    Solid article to understanding how to use cap rates in practice and do a quick sniff test. By having accurate numbers you can make more informed decisions. Think of the cap rate as your expected profits (this doesn't include complex tax filings at the end of the year that would determine your true ROI and money in your pocket). The idea is simply to say if I have a cap rate of %XY, can I invest my money in anything else that will outperform %XY in expected profit margins? If you can invest in something else that has a better %XY (cap rate/profit margin), then you should probably invest in that other thing. But then again, you should dig deeper and consider the tax implications to get your true ROI/money-in-your-pocket calculations. This is a solid list of things to request from the seller that the author provided: Property taxes (normally accurate, because they are public record) Insurance Utilities paid by the owner Maintenance and repairs (1-3% of the value per year, depending on class) Landscaping and snow removal Municipal licensing Property management (5-7% of gross rents) Vacancy (5%) Variable expenses Thanks for this article.
    Sergio Altomare Rental Property Investor from Greater Philadelphia
    Replied about 1 month ago
    Thanks for the comments and feedback Aaron.
    Immanuel Sibero from Carrollton, TX
    Replied about 1 month ago
    There is a discussion thread on this article :-) Cheers... Immanuel