A cap rate tells you the annual return a commercial property would earn if you bought it with cash. It is easy to calculate once you have the right numbers. This guide walks through the formula one step at a time. For the bigger picture on how buyers use cap rates, read cap rates explained.
The Formula
Cap rate = Net operating income ÷ Purchase price
The hard part is not the division. It is getting an accurate net operating income, or NOI.
Step by Step
Start with gross potential rent. This is the total rent the property would collect in a year if every space were leased at current rates.
Subtract vacancy and credit loss. Deduct an allowance for empty space and tenants who do not pay. Five percent is a common starting assumption, but use real history when you have it.
Add other income. Include income from parking, signage, storage, or expense reimbursements.
Subtract operating expenses. Include property taxes, insurance, utilities, repairs, management, and landscaping. Do not include mortgage payments, depreciation, or income taxes.
Divide NOI by the price. The result, shown as a percentage, is the cap rate.
Worked Example 1: Finding the Cap Rate
A small retail building is listed for $1,800,000. The figures are illustrative.
Line | Amount |
|---|---|
Gross potential rent | $180,000 |
Less 5% vacancy and credit loss | −$9,000 |
Plus other income | $3,000 |
Effective gross income | $174,000 |
Less operating expenses | −$48,000 |
Net operating income | $126,000 |
Cap rate ($126,000 ÷ $1,800,000) | 7.0% |
This chart shows how the income shrinks at each step, from gross rent to NOI.
Step | Amount | Chart |
|---|---|---|
Gross potential rent | $180,000 | ████████████████████ |
Effective gross income | $174,000 | ███████████████████ |
Net operating income | $126,000 | ██████████████ |
Worked Example 2: Finding the Price
You can also use the formula to estimate value. If a building earns $95,000 of NOI and similar properties are selling at a 6.75% cap rate, divide $95,000 by 0.0675. The estimated value is about $1,407,000.
Common Mistakes
Using asking rents instead of actual rents. Base the math on signed leases.
Skipping vacancy. Even a fully leased building will not stay that way forever.
Leaving out management. Buyers include a management fee even if the current owner self-manages.
Including the mortgage. Debt service is not an operating expense.
Using last year’s insurance. In Florida, get a current quote, because premiums can change quickly.
Frequently Asked Questions
What is a good cap rate?
There is no single good number. Cap rates depend on property type, tenant quality, lease length, and location. Lower cap rates mean lower risk and higher prices.
Is cap rate the same as return on investment?
Not exactly. Cap rate measures the unleveraged return in one year. Your actual return also depends on financing, appreciation, and how long you hold the property.
To see what your property’s income supports in today’s market, request a free valuation or call Eric Barnes at 941-207-9707.
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About the author: Eric Barnes
Eric Barnes | Commercial Advisor | 941-207-9707
Michael Saunders & Company | MSC Commercial | Sarasota, Florida
Florida License SL3600406 | GRI | RSPS
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