The cap rate formula
Cap rate = net operating income ÷ (property price + up-front repairs)
Net operating income (NOI) is a year of rent, minus vacancy, minus operating expenses: taxes, insurance, repairs, management and reserves. It does not include mortgage payments.
Up-front repairs are the work a property needs before it can earn that rent. Add their cost to the price you enter in the calculator. The full analyzer does the same with your rehab budget.
A worked example
Rent of $2,400 a month is $28,800 a year. A 5% vacancy allowance leaves $27,360. Subtract $9,000 of operating expenses and NOI is $18,360. On a $240,000 purchase that needs no work, the cap rate is $18,360 ÷ $240,000 = 7.65%.
What cap rate tells you, and what it doesn’t
Because it leaves out financing, cap rate lets you compare properties on equal terms, whatever loan you or anyone else might use. That is also its limit: it says nothing about your actual return once a mortgage is involved. For that, use cash-on-cash return.
Cap rate also works in reverse. If similar properties in an area trade at a 7% cap rate, a building with $21,000 of NOI is worth about $21,000 ÷ 0.07 = $300,000.