Cap Rate Example for Rental Property

Step 2: Estimate annual rental income and vacancy

First, convert monthly rent into annual rent, then account for vacancy and credit loss.

Gross annual rent = $2,300 × 12 = $27,600

Assume a 5% vacancy and credit loss rate to reflect turnover and occasional missed payments:

Vacancy allowance = 5% of $27,600 = $1,380
Effective rental income = $27,600 – $1,380 = $26,220

If the property has any additional income (for example, $50/month for a parking space), add that to the effective income figure.

Step 3: Estimate annual operating expenses

Next, estimate the property's annual operating expenses. These are the costs of running the property, not including your mortgage payment. For this example:

• Property taxes: $4,800 per year
• Landlord insurance: $1,400 per year
• Maintenance & repairs (budget): $1,800 per year
• Lawn care and snow removal: $900 per year
• Property management (8% of effective income): 0.08 × $26,220 ≈ $2,098

Total operating expenses ≈ $4,800 + $1,400 + $1,800 + $900 + $2,098
Total operating expenses ≈ $10,998

You can refine these numbers with quotes from vendors and managers, but this estimate is detailed enough for an initial cap rate calculation.

Step 4: Calculate net operating income (NOI)

Net operating income is effective income minus operating expenses:

NOI = Effective income – Operating expenses
NOI ≈ $26,220 – $10,998 = $15,222

This $15,222 represents the property's annual income from operations before any debt service or income taxes. It is the key input for the cap rate formula.

Step 5: Compute the cap rate

Now divide NOI by the purchase price (or your offer price) to find the cap rate:

Cap Rate = NOI ÷ Price
Cap Rate ≈ $15,222 ÷ $320,000 ≈ 0.0476, or about 4.8%

At the asking price of $320,000, this rental property has an approximate cap rate of 4.8%. This is the income yield you'd earn if you bought the property all-cash at that price, before financing.

Step 6: Interpret the cap rate in context

Whether 4.8% is "good" depends on the local market and your goals. In some high-demand, supply-constrained metros, a 4.8% cap rate may be normal or even attractive. In other markets, investors might expect 6%–8% or more for similar properties.

When interpreting the result, ask:

• How does 4.8% compare to other recent sales in this neighborhood?
• Is there room to increase rents or reduce expenses to lift NOI over time?
• Does the property offer strong appreciation potential or strategic value?

If local comps show similar homes trading at 5.5%–6% cap rates, you might conclude this property is slightly overpriced at the current rent and ask price—or that your income assumptions are conservative and NOI could be improved.

Step 7: Test alternative scenarios with a calculator

Before you decide to walk away or move forward, test a few "what if" scenarios. For example:

• What if you negotiate the price down to $300,000?
• What if you raise rent to $2,450 over the first year to match nearby comps?
• What if you self-manage initially, reducing management expense?

You can quickly model these changes in the Cap Rate Calculator and Property Investment Analyzer to see how they impact NOI, cap rate, and overall returns.