What Is a Cap Rate? NOI First, Then the Formula, Then What It Leaves Out

A listing advertises a duplex at $400,000 with an "8.5% cap rate." Rebuilt with a vacancy allowance, a property manager, and a reserve for the roof, the same building yields 5.5%. Nothing about the property changed between those two numbers. The only thing that changed was who did the arithmetic, and that is the whole reason to learn how a cap rate is built rather than reading the one you are handed.

Start with NOI, not the rate

A cap rate is only as honest as the net operating income underneath it. NOI is what the property earns in a year after the costs of operating it, before any mortgage payment, income tax, or depreciation. Here is the duplex, built line by line with two units renting at $1,700 a month:

The seller's version kept the $40,800 of rent and subtracted only taxes and insurance: no vacancy, no manager because they self-managed, no reserve because the roof has not failed yet. That produces an NOI of $33,800 and the advertised 8.5%. Every one of the missing lines is a real cost that will land on the next owner, which is why the first rule of cap rates is to rebuild NOI with your own numbers before believing anyone's ratio.

The formula

Cap rate = NOI / price. For the duplex, $22,160 / $400,000 = 5.5%. Read it as the yield you would earn in year one if you paid cash and collected the NOI: the property returns 5.5% on its price before any loan enters the picture. The formula also runs in reverse, which is how income property gets valued. Price = NOI / cap rate, so if similar buildings in the area trade at a 6% cap, this NOI supports about $369,000; at 5%, about $443,000. A single point of cap rate moved the value by roughly $74,000, which is why buyers argue about the rate and sellers argue about the NOI.

What a cap rate ignores

The ratio is deliberately narrow, and its blind spots are where real returns are won and lost.

• Financing. Put 25% down and borrow $300,000 at 7% over 30 years, and annual debt service is about $23,950. NOI of $22,160 minus that leaves cash flow of roughly −$1,790 a year: the building loses money every month even though the cap rate is positive. The rule underneath is simple. When the cap rate is below the loan rate, borrowing lowers your return; when it is above, borrowing amplifies it. The loan does retire about $3,050 of principal in year one, which softens the loss, but a 5.5% cap financed with 7% money is a bet on the next item, not on income.
• Appreciation and rent growth. A cap rate is a photograph of year one. A 5.5% cap in a market where rents grow 4% a year can outrun an 8% cap in a flat one over a decade, and the ratio cannot see that. It also cannot see taxes: the depreciation deduction that shelters part of the rental income, or the option to defer the gain on sale through a 1031 exchange. Those belong in a full projection, not in the screen.
• Your time and your risk. The 8% management line prices a manager, not the hours an owner spends on the building anyway, and nothing in the ratio prices the chance that both units sit empty for a quarter.

The cap rate calculator handles the NOI build and the unleveraged number on its own; the rental property calculator builds NOI, cap rate, and the financed cash flow together, and the mortgage calculator prices the debt service for any down payment and rate you are considering.

Comparing properties with it

Cap rates are most useful across listings in the same market, where they turn different prices and rents into one comparable number. Two properties at the same cap rate deserve a look at the quality of the NOI: a long-term tenant in a ten-year-old building is a different 5.5% from a vacant unit in a building with a failing furnace. Two properties at different cap rates in the same market are telling you something about risk. If a $300,000 building down the street throws off $21,000 of NOI, a 7% cap, and it is older, rougher, and needs a roof, the extra 1.5 points are compensation for those things, not a free lunch. The rate is the market's price for the risk it sees.

Why "good" depends on the market

There is no universal good cap rate, only a good one for a given place, building, and moment. Dense coastal metros trade at low cap rates because buyers there expect steady occupancy and price growth, and they accept a thin current yield to get it. Smaller and slower markets trade at higher caps because the growth story is weaker and the tenant base thinner. Newer buildings in strong locations price below older ones with deferred maintenance. And cap rates drift with interest rates over time, because a property competes for capital with everything else that pays a yield. The practical benchmark is the spread over a risk-free bond: a cap rate a point or two above what a government bond pays is asking you to accept vacancy, repairs, and the near-total lack of liquidity for very little extra return, while a wide spread is paying you for those things. Whether the payment is enough is a judgment, and the ratio cannot make it for you.

The 1% rule as a first screen

Before building an NOI for every listing, the 1% rule sorts the pile: monthly rent should be at least 1% of the purchase price. The duplex rents for $3,400 a month against $400,000, or 0.85%, a mild fail. The rule maps loosely to cap rates because operating costs tend to consume something like 40–50% of rent, so a property that clears 1% usually lands around a 6–7% cap. It is a screen and nothing more. It knows nothing about taxes, condition, or the market, so it belongs at the start of the process, and the NOI table belongs at the end.

A rental is an asset, a loan, and a stream of cash flows all at once, and it only makes sense inside the rest of your balance sheet. Tracking it alongside everything else shows whether the building is adding to your net worth or quietly eating the returns of everything around it.