Real estate investors calculate a “cap rate” to estimate the rate of return on a property. The cap rate is a simple calculation that determines whether or not a real estate investment will be worthwhile. 

The cap rate formula is the following:

Cap Rate = Annual Net Operating Income / Property FMV

A rental property’s net operating income is the gross rent minus all operating-related expenses. Operating expenses include:

  • Property taxes
  • Regular repairs and maintenance
  • Insurance
  • Legal and professional fees
  • Advertising
  • Cleaning fees
  • Utilities

What items are generally excluded from the NOI calculation?

  • Interest Expense. NOI excludes interest expense, principal payments, and other debt service costs because these vary widely between investors.
  • Depreciation Expense. Depreciation is a non-cash expense that doesn’t impact the property’s net cash flow. Therefore, investors exclude it from the NOI calculation; however, it is very important for federal tax purposes. 
  • Capital Expenditures. The cap rate formula analyzes the property’s regular operating income and expenses, excluding major capital expenditures that do not occur annually.