Guide

How to calculate the cap rate of a property

The cap rate is the metric that lets you compare properties without financing distorting the reading. Here's what it is, the formula, a step-by-step example and how to interpret it.

Definition

What the cap rate is

The cap rate (capitalization rate) measures a property's annual operating return over its price, ignoring financing. It relates net operating income (NOI) to the purchase price.

Unlike gross yield, it deducts the cost of operating the property. That's why it compares different assets on a like-for-like basis: two homes with the same gross yield can have very different cap rates depending on their costs.

The formula

Cap rate = Annual NOI ÷ Purchase price × 100

Example

How it's calculated, step by step

Take a €200,000 property with a market rent of €950 per month (€11,400 a year). These would be the estimated annual operating costs:

Item	Annual amount
Gross rent	€11,400
− Property tax	€380
− Community fees	€720
− Insurance (home + arrears)	€280
− Maintenance and reserve	€700
− Vacancy (≈1 month)	€950
= NOI	€8,370

Comparison

Cap rate against other metrics

The cap rate doesn't replace the other metrics: it complements them. Each answers a different question.

Metric	Formula	What it answers
Gross yield	Annual rent / price	Worth a second look?
Cap rate	NOI / price	How does it compare with other assets?
Leveraged cash flow	NOI − mortgage instalment	How much cash per month?
Leveraged ROE	Net profit / equity	What does my money return?

Reading

How to interpret the cap rate

A higher cap rate suggests higher operating return, but usually also reflects more risk or a worse location. A lower cap rate is common in prime areas, where the investor accepts less rent in exchange for stability and appreciation potential.

There is no universal 'good' cap rate: it depends on the area, asset type, risk and your cost of capital. The useful reading is relative —how it sits against the area average and alternatives— and always alongside leveraged cash flow.

What it misses

What the cap rate doesn't tell you

The cap rate is useful but partial. It doesn't capture:

·Financing: it ignores the mortgage, rates and the effect of leverage.
·Appreciation: it only measures rent, not potential capital gain on sale.
·Taxation: tax treatment can change the real return.
·Assumption risk: an optimistic NOI inflates the cap rate on paper.

To avoid

Common mistakes when calculating it

Using gross rent as NOI

Forgetting to deduct property tax, fees, insurance, maintenance and vacancy.

Subtracting the mortgage instalment

NOI is before financing; the instalment belongs in cash flow, not the cap rate.

Assuming zero vacancy

One vacant month per year is already ~8% of rent.

Comparing different areas without context

4% in a prime area and 6% in a risky one aren't comparable.

Frequently asked questions

What cap rate is considered 'good'?

There is no universal threshold. It depends on the area, asset type, risk and your cost of capital. More useful than a number is understanding how it sits against the area average and whether the deal survives an adverse scenario.

Does the cap rate include the mortgage?

No. The cap rate is computed on NOI, which is before financing. The mortgage effect shows in leveraged cash flow and ROE, not in the cap rate.

Cap rate or gross yield?

Gross yield is a quick filter; the cap rate, by deducting costs, lets you compare assets on a like-for-like basis. To decide, you need both, plus leveraged cash flow.

Is this investment advice?

No. This is informational content. Ratio Planning provides quantitative analysis and does not constitute investment advice within the meaning of Directive 2014/65/EU (MiFID II) nor a personalised recommendation.

Ratio Planning provides quantitative analysis. The reports and tools do not constitute investment advice within the meaning of Directive 2014/65/EU (MiFID II) nor a personalised recommendation.

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