Capitalization rates, also known as cap rates, get thrown around constantly in commercial real estate, but many investors still struggle with how to calculate them – and how to use them effectively. The good news is, the math isn’t complicated. What matters most is understanding what goes into the formula and how it applies to your investment decisions.
Let’s break it down step by step.
Start with Gross Rent
The first step is to look at the property’s gross annual rent. This is the total rent you expect to collect if every space is occupied and paying in full. At this stage, you’re not considering vacancy or expenses – just the raw income potential.
Subtract Vacancy
No property is fully occupied every day of the year. Every market has an average vacancy rate, and you should use that number – NOT your actual current vacancy rate – as part of your calculation. For example, if your market vacancy rate is 5%, you’ll reduce your gross rent by that percentage to get a realistic income number.
In other words, 95% of your gross rent is the number you’d be working with moving forward.
Deduce Operating Expenses
Next, take out all property expenses: taxes, insurance, utilities, maintenance, and management. One common mistake is excluding a management fee if you plan to self-manage. Don’t skip it. Banks, appraisers, and other investors will always include a management line item, and leaving it out will give you an inflated number.
Once you subtract expenses, what’s left is known as your net operating income, or NOI.
Divide by Purchase Price
Now you’re ready for the actual cap rate calculation. Take the NOI and divide it by the purchase price of the property. That number is your cap rate.
Cap Rate = Net Operating Income / Purchase Price
This is the core formula investors use to measure return based purely on the property’s income, without considering financing or tax impacts.
Don’t Forget Reserves
A step many investors skip is setting aside reserves. Roofs, HVAC systems, and parking lots all need to be replaced eventually. While reserves aren’t part of the strict cap rate formula, they do matter for your real cash flow. A property that looks strong on paper can turn into a drain if you don’t plan ahead.
What’s a “Good” Cap Rate?
Cap rates shift with market conditions, but as a rule of thumb, investors often look for cap rates about 1% higher than the prevailing interest rate.
For example, if interest rates are at 7%, an 8% cap rate would generally be considered healthy. In today’s competitive market, though, many deals are trading at cap rates equal to the interest rate. Why? Because investors are betting on future appreciation and value-add potential to boost their returns.
Cap Rate in Action: An Example
Let’s say you’re looking at a small retail center with five tenants. Together, they pay $250,000 per year in gross rent.
- Subtract Vacancy:
- The market vacancy rate is 5%.
- $250,000 x 95% = $237,500 effective gross income.
- Deduct Expenses:
- Property taxes: $20,000
- Insurance: $5,000
- Utilities for common areas: $7,500
- Maintenance and repairs: $12,500
- Management fees: $10,000
- Total expenses: $55,000
- $237,500 – $55,000 = $182,500 NOI
- Divide by Purchase Price:
- The seller is asking $2,200,000.
- $182,500 / $2,200,000 = 0.083, or an 8.3% cap rate
That’s how the math comes together for a real property. If current interest rates are around 7%, then an 8.3% cap rate looks attractive. If interest rates rise higher, you may need to revisit the numbers to be sure it still works.
Final Thoughts
Cap rates aren’t the whole story, but they’re one of the most important tools for evaluating an investment. They help you to compare opportunities on equal footing, understand your expected return, and avoid overpaying for properties that won’t perform.
Many investors we work with rely on our insight to evaluate properties with confidence and make strategic buying decisions. If you’re considering your next investment, contact us to learn how we can help you identify opportunities that deliver long-term value.
