Cap Rate & NOI Explained (Formula + Worked Example)

If you only learn two numbers in commercial real estate, make them NOI and cap rate. Net Operating Income tells you how much cash a property generates before debt enters the picture. Cap rate converts that income into a valuation — it is how sellers price buildings and how buyers decide whether that price makes sense. Get these two concepts wrong and everything downstream — loan sizing, cash-flow projections, exit scenarios — is built on a shaky foundation.

What is NOI and why does it exclude debt?

Net Operating Income is the annual income a property produces after paying all operating expenses but before mortgage payments, depreciation, or income taxes. That last point is deliberate and important: by keeping debt out of NOI, you get a number that reflects the property's earning power regardless of how it is financed. Two buyers — one paying all cash, one taking out a large loan — will see the same NOI, which is why lenders and appraisers can use it as a common baseline.

The standard NOI formula, as used in commercial real estate underwriting, is:

A common shortcut you will see is simply "Gross Rent minus Expenses equals NOI," but that skips vacancy — which is dangerous. Buildings are rarely 100% occupied; the gap between theoretical rent roll and actual collected rent matters especially in commercial leases where a single tenant departure can shift income sharply. Always model at least a 5% vacancy allowance for stabilized assets and higher for anything with near-term lease expirations.

What is cap rate and what does it actually measure?

The capitalization rate — universally called "cap rate" — is simply NOI divided by the property's value, expressed as a percentage. It is the unleveraged annual return the property produces if purchased with all cash.

That second form — Value = NOI ÷ Cap Rate — is how commercial property is actually appraised and priced. A broker quoting a "7 cap" on a building is telling you that at the asking price, the property produces a 7% unleveraged return. If you think the market cap rate for that property type and location is 6.5%, the building is fairly priced or slightly cheap. If the market is at 7.5%, the price needs to come down.

Cap rates move inversely to property values: when investors bid prices up, cap rates fall. When sentiment sours and prices drop, cap rates rise. This is the same mechanism as bond yields — and for the same reason, rising interest rates tend to put upward pressure on cap rates, since investors need a higher return to justify buying real estate instead of risk-free bonds.

Where do 2026 cap rates actually sit?

Cap rate ranges vary widely by market, property type, and asset quality. According to CBRE's 2026 US Real Estate Market Outlook and data published by Matthews Real Estate Investment Services, the following ranges reflect mid-2026 conditions for stabilized US assets:

These figures are reference points, not guarantees. A specific submarket, lease structure, tenant credit, or property condition can shift a deal outside any of these ranges. Always benchmark against recent closed transactions in the same submarket — not against national averages.

A fully worked example with 2026 numbers

Suppose you are evaluating a 12-unit apartment building in a secondary Sunbelt market. Here is how the NOI and cap rate would flow through from the ground up:

Notice that capital reserves ($100/unit/month) are included as an operating expense above. Some investors exclude them from NOI calculations; others include them. The practice you choose matters less than applying it consistently and disclosing it clearly when sharing underwriting with partners or lenders.

NOI versus cash flow: why debt changes everything

NOI deliberately ignores financing — that is its strength as a comparison tool. But once you actually buy a property, your real-world results depend on how the deal is financed. Two deals with identical NOI can produce radically different cash flows depending on loan size and interest rate.

Take the example above: $143,084 in NOI on a $2,150,000 purchase. At 75% LTV the loan is $1,612,500. At a 6.75% interest rate on a 30-year amortization, annual debt service is roughly $125,700. That leaves before-tax cash flow of:

$143,084 − $125,700 = $17,384/year

On $537,500 of equity invested (the 25% down payment plus closing costs), that is a cash-on-cash return of approximately 3.2% — a thin yield in a 6.75% rate environment. The same property at 5.5% interest would produce annual debt service of about $109,900 and cash-on-cash closer to 6.2%. This is why the rate environment at acquisition matters so much: it does not change NOI, but it dramatically changes what cash you actually pocket.

The DSCR: how lenders read NOI

Commercial lenders do not simply look at cap rate when deciding whether to approve a loan. They focus on the Debt Service Coverage Ratio (DSCR), which compares NOI directly to the proposed annual mortgage payment:

A DSCR below 1.0 means the property loses money every month on a cash basis — no amount of equity appreciation makes that sustainable as a long-term hold. If a lender's DSCR minimum is blocking a deal you believe in, the lever you can pull is either a larger down payment (reducing debt service) or finding genuine rent upside that will grow NOI quickly enough to satisfy the ratio once leases roll.

Using cap rate to set a maximum purchase price

One of the most practical uses of the cap rate formula is working backward from a target yield to set a maximum bid. If you need at least a 6.5% cap rate to make a deal pencil with your financing and return targets, you can calculate your ceiling instantly:

Max price = NOI ÷ Target cap rate = $143,084 ÷ 0.065 = $2,201,292

At $2,150,000 asking price, the deal just barely clears a 6.5% cap — leaving almost no negotiating cushion. If expenses come in higher, rent assumptions prove optimistic, or interest rates move, that thin margin disappears. Most experienced buyers build in at least 50–100 basis points of underwriting conservatism — meaning they would want to buy this deal closer to a 7.0% cap ($143,084 ÷ 0.07 = $2,044,057) to leave room for error.

Common mistakes when calculating NOI

NOI calculations look simple but hide several places where investors routinely go wrong:

• Using gross rent instead of effective gross income. Vacancy is real, especially in commercial leases where a single tenant can be 30–50% of the rent roll. Using full occupancy to inflate NOI leads directly to overpaying.
• Excluding capital reserves. HVAC systems fail, roofs age, and parking lots crack. A building with no reserve line in the NOI is a building where surprise expenses will destroy your cash flow year after year.
• Trusting seller-provided expense numbers without verification. Sellers have an incentive to show low expenses (higher NOI, higher price). Always request at least two years of actual tax returns and utility bills, then rebuild the expense schedule yourself from market rates.
• Confusing cash flow with NOI. Cash flow subtracts debt service; NOI does not. Never tell a lender your NOI is $143,000 and then describe your $17,000 after-debt cash flow as "basically the same thing."
• Applying a national average cap rate to a specific deal. A 5.6% national multifamily average means little for a specific garden-apartment complex in a tertiary market. Comp cap rates from actual recent sales in that submarket are the only number that matters at the deal level.

Cap rate compression and exit risk

When you buy at one cap rate and sell later at a different cap rate, the difference can amplify or erode your returns dramatically. If you buy a property at a 7.0% cap and sell five years later when the market has compressed to 6.0%, you effectively get a price bonus on top of any NOI growth. The reverse is just as true: buying at 5.5% and selling into a 7.0% cap environment means your exit price will be substantially lower than a naïve NOI-growth projection would suggest.

This is called exit cap rate risk, and it is one of the most commonly underestimated risks in CRE investing. When building a multi-year proforma, always stress-test your exit at cap rates 50–100 basis points higher than your entry cap. If the deal still works at a wider cap, you have a reasonable margin of safety. If it only works if cap rates stay flat or compress, you are implicitly betting on favorable market conditions at the moment you need to sell — a bet that does not always pay off.

Figro's guides are educational and independent. They are not financial, legal, or investment advice. Cap rate ranges cited reflect mid-2026 market data from CBRE's 2026 US Real Estate Market Outlook and Matthews Real Estate Investment Services research. Some pages include affiliate links; if you purchase through them we may earn a commission at no extra cost to you.