A cap rate relates a property’s annual net operating income to its price or value. It helps compare income assumptions, but it does not include your mortgage, predict appreciation, or establish that an investment is suitable. The useful starting point is the income statement behind the percentage.
What is net operating income?
For this learning center, NOI is effective annual property income minus recurring operating expenses. Start with scheduled rental income, subtract vacancy and collection losses, include supportable recurring other income, then subtract property taxes, insurance, management, utilities paid by the owner, ordinary maintenance, and other operating costs.
Debt principal and interest, owner income taxes, and depreciation are excluded here. Major capital work and reserve contributions are shown separately below NOI. Other reports and lenders may classify some items differently, especially replacement reserves. Reconcile the definition before comparing numbers. The California BOE’s income-approach lesson explains rates and income relationships.
How is cap rate calculated?
Cap rate = annual NOI ÷ purchase price. In a hypothetical example, $120,000 of scheduled rent less $6,000 of vacancy and collection loss and $44,000 of operating expenses gives $70,000 of NOI. At a $1,750,000 price, the cap rate is 4.00%. These are teaching figures, not current San Francisco rents, costs, or a suggested purchase.
For a property already owned, state whether the denominator is original purchase price or a supportable current value. Those calculations answer different questions. Dividing NOI by an assumed market cap rate can illustrate a value, but selecting that rate requires evidence and judgment. BOE’s rate-derivation lesson provides context.
Which cap rate is being advertised?
- Trailing: based on an identified historical period and actual operations, subject to any stated adjustments.
- In-place: based on current lawful rents and clearly stated current expense assumptions.
- Stabilized or pro forma: based on a future operating scenario that may require time, capital, approvals, or leasing.
Ask for the period, rent roll, collections, expense detail, and adjustments. An annualized strong month is not a full year of demonstrated performance. A projected rent increase is not collected income. Review the due-diligence guide before accepting the advertised NOI.
Does a higher cap rate mean a better purchase?
Not by itself. A higher stated rate may reflect different condition, tenancy, expenses, location, financing constraints, or assumptions. Compare properties with the same accounting basis and investigate why the rates differ. Do not insert a universal “good San Francisco cap rate” without dated, relevant transaction evidence.
Why can a positive cap rate still produce negative cash flow?
The mortgage and capital needs still have to be funded. In the example, $60,000 of annual debt service leaves $10,000 before reserve contributions. Setting aside $12,000 for future capital work leaves a negative $2,000 after that allocation. Neither cap rate nor the reserve allocation is the owner’s taxable income.
Use the worksheet below, then read cash flow and financing and expenses and reserves. Compare a base case with lower collections and higher costs instead of treating one percentage as the decision.
Rental income worksheet
Start with these hypothetical teaching figures or enter your own assumptions. All dollar entries are annual except price and initial cash. The worksheet runs in your browser and does not save or submit the entries.
Operating expenses include property taxes, insurance, management, and ordinary maintenance. Exclude debt, owner income tax, depreciation, and the capital allocation. Other income is entered net of its expected losses. Capital allocation is a reserve contribution or direct capital budget; do not count the same spending twice. Initial cash includes down payment, closing costs, immediate work, and initial funding.
With the example inputs: NOI is $70,000, cap rate is 4.00%, simple DSCR is 1.17×, and cash after debt and capital allocation is −$2,000 (−0.33% of initial cash).
This simplified annual view excludes appreciation, sale costs, owner income taxes, inflation, timing within the year, and future changes. It is not an appraisal, lender decision, or investment recommendation. Loan underwriting may use different income and reserve definitions.
Use this guide to organize questions for the relevant property, legal, tax, lending, and insurance professionals. Actual requirements and financial outcomes depend on the property and the proposed plan.