Cap Rate Explained, Without the Mortgage Mistake
NOI divided by price, and the single mistake that makes most quoted cap rates wrong.
Cap rate is net operating income divided by price. A duplex that costs $200,000 and produces $16,000 of NOI a year is an 8% cap. The formula is one line; the mistakes are in what people put inside it.
What belongs in NOI
NOI is all the income the property produces minus its operating expenses. Every line on the operating side counts. The loan never does.
| Line item | NOI treatment |
|---|---|
| Rent | Income, counts |
| Laundry, parking, and fees | Income, counts |
| Taxes and insurance | Expense, subtract |
| Management and repairs | Expense, subtract |
| Vacancy | Expense, subtract |
| Utilities you pay, and HOA dues | Expense, subtract |
| Mortgage principal | Never in NOI |
| Mortgage interest | Never in NOI |
| Purchase price | $200,000 |
| All income minus operating expenses (NOI) | $16,000 |
| Cap rate: $16,000 divided by $200,000 | 8% |
One line of division, but it only means something if the $16,000 is true NOI: every operating expense in, the mortgage out.
Why the mortgage stays out
Cap rate ignores debt deliberately. It measures the property as an income-producing asset, so two buyers with completely different loans land on the same number for the same building. That is exactly what makes it comparable across deals and across buyers.
Subtract a mortgage and you are measuring your financing, not the asset. What is left after debt service has its own name (cash flow) and its own metric, cash-on-cash return. Both are useful; neither is cap rate.
A market number, not a property number
Is 8% good? The question has no standalone answer, because a cap rate is only meaningful next to what comparable buildings in that submarket trade at.
Put the duplex in a market trading at 6%. Its $16,000 of NOI would price at roughly $267,000 at the market cap, yet it is offered at $200,000: that gap is either an opportunity or a warning (deferred maintenance, a rough pocket, inflated pro-forma income), and your job is to find out which.
Chasing the highest cap rate across markets feels like discipline, but it just means buying where the market prices in the most risk. A high cap is the market's compensation for something. Find out what it is before you call the number an opportunity.
Charge yourself, even when you self-manage
Include vacancy and management in NOI even if you self-manage and your units are full. Skipping them flatters the deal by the cost of your own unpaid labor. The next buyer's appraisal will include them, so you would be quoting yourself a cap rate no one else will ever see.
Compute NOI on a property you know: every operating expense in, no mortgage, then divide by price. Compare the result against what similar properties in the same submarket trade at. That comparison, not the raw number, is the analysis.
Put this lesson to work on a live address.
Run the rental numbers on any address
