Cap rate is one of the first terms you hear when you start reading about real estate, and one of the last ones anyone explains properly. Most definitions stop at the formula. That leaves out the useful parts: what goes into the number, what the number ignores, and when it is the wrong metric entirely.
I care about what a number includes before I care about how big it is. This post walks through cap rate that way: the formula, a full worked example with every line item visible, and then the reason cap rate played almost no role in the decision to buy my own duplex.
New to the owner-occupied side?
The house hacking guide covers the overall strategy. This post is about one specific measuring stick.
How to calculate cap rate
Cap rate is net operating income divided by purchase price. A property that produces $19,200 a year in net operating income and costs $300,000 has a cap rate of 6.4%. That is the whole formula. The work is in the NOI, because NOI is where every mistake hides.
What counts as net operating income (NOI)?
Net operating income is the property’s income minus its operating expenses, before any loan payment. The dividing line trips people up constantly, so here it is as a table:
| Counted in NOI | Not counted in NOI |
|---|---|
| Rent from all units | Mortgage principal and interest |
| Other income (parking, laundry, storage) | Down payment and closing costs |
| Minus vacancy allowance | Loan fees and points |
| Minus property taxes | Depreciation (a tax concept, not a cash cost) |
| Minus insurance | Major capital projects (roof, furnace), by convention |
| Minus repairs and maintenance | Your own unpaid labor |
| Minus property management | Income taxes |
| Minus owner-paid utilities |
The most important row is the first one on the right. The mortgage is not in NOI. Cap rate describes the property, not the deal you personally struck to buy it. A building bought with cash and the same building bought with 3.5% down have identical cap rates, and wildly different monthly realities for the person who owns them.
Cap rate example: a $300,000 duplex, line by line
Take a hypothetical $300,000 duplex where both units rent out. The numbers below are round on purpose; the point is the structure.
| Line item | Annual amount |
|---|---|
| Gross rent ($2,600/month, both units) | $31,200 |
| Vacancy allowance (5%) | −$1,560 |
| Property taxes | −$3,600 |
| Insurance | −$1,800 |
| Repairs and maintenance | −$2,400 |
| Property management (about 8.5%) | −$2,640 |
| Net operating income | $19,200 |
Cap rate: $19,200 divided by $300,000 = 6.4%.
Two things to notice. First, expenses ate more than a third of the gross rent before any mortgage payment existed. If you compute a cap rate from rent minus taxes and nothing else, you will get a flattering number that no lender, appraiser, or experienced buyer will recognize.
Second, I included management even though many small landlords self-manage. If you skip that line, the cost stays; you have simply agreed to do the job yourself for free, and the building’s numbers should not get credit for your unpaid hours.
What is cap rate used for?
What cap rate is good for
Cap rate answers one question well: how hard does this property work relative to its price, independent of financing? That makes it good for a few specific jobs.
What cap rate lets you compare
It lets you compare two properties in the same market on equal footing, since neither number depends on who is buying. It gives you a rough sense of how a market prices risk, because a property that must offer a higher yield to attract buyers is usually one the market trusts less, whether that is the neighborhood, the building age, or the tenant base. And it is the language sellers, agents, and commercial lenders already speak, so you need to understand it even if you never make a decision with it.
What it will not tell you is whether you personally will make money. Your rate, your down payment, and your loan term decide that, and cap rate excludes all three by design.
Cap rate vs. cash-on-cash return
These two metrics get confused constantly, and the difference is exactly the mortgage:
| Cap rate | Cash-on-cash return | |
|---|---|---|
| Formula | NOI ÷ purchase price | Annual cash flow after loan payment ÷ cash invested |
| Includes your financing? | No | Yes |
| Changes if rates change? | No | Yes |
| Best for | Comparing properties | Judging your specific deal |
The same 6.4% cap rate building can be a comfortable hold at one interest rate and a monthly loss at another. Cap rate cannot see the difference. Cash-on-cash can, and I wrote a separate breakdown of it in cash-on-cash return, explained with a real example.
Cap rate for house hacking: why it barely mattered on my duplex
Here is the part that changes if you are buying a property to live in part of it: cap rate describes a building that does not exist yet.
How cap rate works on an owner-occupied duplex
I bought a $470,000 duplex and moved into one unit. My unit earns no rent while I live here, so operating income is well below what a cap rate assumes. I judged the purchase on effective housing cost: the full payment, minus the upstairs rent, minus what the basement earns. That cut my housing cost to a fraction of the payment. Cap rate cannot show that, because it has no concept of an owner living inside the asset.
Cap rate becomes relevant to a house hacker later, at the exit. When you move out and the whole building rents, or when you sell to an investor who will value it partly on its income, the metric wakes up. So I treat it as a describe-the-future number: worth computing, worth understanding, not worth choosing a home by.
What is a good cap rate?
The unsatisfying and true answer: it depends on the market, and it moves over time. A cap rate that would be a bargain in one metro would signal a problem property in another, and the level that attracts buyers shifts with interest rates and local rent trends. That is why I am deliberately not printing a good number here for you to anchor on. It would be stale before long, and wrong for your market on day one.
What counts as a good cap rate
The durable version of the advice: compare cap rates within the same market and property type, be suspicious of an outlier in either direction, and never let a single ratio substitute for the full monthly math. For the complete pre-purchase walkthrough, see how to run the numbers on a rental before you buy.
Put a cap rate next to the numbers that decide the deal.
The free house hacking calculator. Enter a price, a rent and your loan terms, and it returns cash flow, cash-on-cash and your effective housing cost in one pass.
Frequently asked questions
Does cap rate include the mortgage payment?
No. Net operating income is calculated before any debt payment, so cap rate is identical whether the buyer pays cash or puts 3.5% down. That is the point of the metric, and also its biggest limitation for a regular buyer with a loan.
Are capital expenses like a roof included in NOI?
Capital expenses are excluded from NOI under the usual convention, which is one reason cap rates flatter older buildings. Whatever the convention, your own analysis should set aside reserves for big components, because the roof does not care which formula you used.
Is cap rate useful for a house hack?
Cap rate is a pure-rental metric, so it says little while you occupy part of the property. It matters at the exit, when the building rents fully or sells on its income. While you live there, effective housing cost is the number to manage.
Keep going
- House hacking calculator, the full monthly math on any listing, free.
- Cash-on-cash return, explained, the financing-aware companion metric.
- How to run the numbers on a rental, the end-to-end pre-purchase walkthrough.
Where my figures come from
The $300,000 duplex is a hypothetical worked example with deliberately round figures; it is not a listing. Purchase price, payment and rent figures for my own duplex are from my closing documents and monthly statements.
If you have a listing in front of you, skip the ratio debates and run the whole thing in the free house hacking calculator. It computes cash flow, cash-on-cash, and your effective housing cost in one pass, no account required. And if you want a second pair of eyes on a specific deal, send it to me. I read every one.
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