How to calculate cap rate — and the four numbers that matter more

Cap rate is the fastest way to compare rental properties as if you paid cash for both. But a deal is screened properly only when cap rate is computed from an honest NOI — and checked against cash flow, cash-on-cash return and DSCR. Here is the full chain, with one worked example all the way through.

Step 1 — Effective rental income

Never budget 0% vacancy, even if the property is rented today. One empty month a year is 8.3%; strong markets may justify ~5%, slow ones 10%.

Step 2 — Operating expenses (all of them)

Taxes, insurance, repairs & maintenance, property management, HOA, utilities you pay — and a CapEx reserve. Roofs, HVAC systems and appliances do not send invoices every month, but they always arrive. A reserve of ~5% of rent, modeled as its own line, keeps them from ambushing year three.

Step 3 — NOI and cap rate

NOI excludes the mortgage — it measures the property, not your loan. That is why cap rate compares deals fairly; it is also why a "good" cap rate can still lose money once debt is added.

Step 4 — Cash flow, cash-on-cash, DSCR

DSCR below 1.0 means the rent does not cover the debt — most lenders want 1.2 or better. Break-even rent is the rent at which cash flow is exactly zero; if the market rent is below it, the deal cannot work at this price.

The worked example

A 5.0% cap rate looks acceptable in a listing. The full chain says otherwise: the property loses money every month and needs $2,180 in rent — $380 more than it gets — just to break even. This is a walk-away at $250K, and the cap rate alone would never have told you.

The mistakes that flatter deals

• Vacancy at 0% — inflates effective income by 5–10%.
• No CapEx reserve — makes year one look fine and year three a surprise.
• Asking-price ARV/rent from the seller — verify against your own comps and listings.
• One number, no stress test — check rent −10% and −20% before you offer, not after you close.