Understanding how to evaluate an investment property goes beyond looking at the asking price or projected rent.
One of the most important performance metrics in commercial and multifamily real estate is the capitalization rate, commonly known as the cap rate.
This metric helps investors determine whether a property aligns with their financial goals and market expectations.
In this article, we break down how the cap rate works, how to calculate it correctly, and how to use it to analyze a real-world multifamily property example in Southern California.
What Is Cap Rate and Why It Matters in Real Estate Investing
The cap rate is a key performance indicator used to measure the return on an investment property based on its income. It allows investors to compare properties across different markets, asset classes, and price points using a standardized formula.
How to calculate cap rate in real estate
Cap rate is calculated by dividing a property’s net operating income by its purchase price or market value. While the formula itself is simple, arriving at an accurate net operating income requires careful attention to income assumptions and expense calculations. This is where many investors make critical mistakes.
The Cap Rate Formula Explained
The general formula for calculating cap rate is straightforward:
Cap Rate = Net Operating Income ÷ Purchase Price
The challenge lies in properly calculating the net operating income, also known as NOI. NOI represents the income a property generates after operating expenses are deducted, but before financing costs, depreciation, or taxes related to ownership structure.
To demonstrate how this works in practice, let’s look at a multifamily property example.
Step One: Calculating Adjusted Gross Rental Income
The starting point for NOI is annual gross rental income. In this example, the property generates $223,140 in annual gross rents.
From this number, a vacancy factor must be applied. Even well-performing properties experience vacancies, and lenders typically assume a minimum vacancy rate of 5%.
Using a conservative vacancy assumption provides a buffer against unexpected income interruptions and reflects realistic operating conditions.
After subtracting a 5% vacancy factor, the adjusted annual rental income comes to $211,948.
Step Two: Identifying True Operating Expenses
To calculate net operating income accurately, all realistic annual operating expenses must be included.
Using outdated tax assessments or excluding management costs can significantly distort the cap rate and lead to poor investment decisions.
Property taxes are one of the largest expenses and must be calculated using the new assessed value based on the purchase price.
In Los Angeles County, combined property tax rates average approximately 1.25% of the purchase price. For a property priced at $2,950,000, annual property taxes total $36,875.
Insurance is estimated at $10,000 per year. Property management is calculated at approximately 8% of gross rents, even if the owner plans to self-manage.
Lenders require this assumption to ensure financial viability in case third-party management becomes necessary. In this case, management costs total $17,848 annually.
Utilities such as water are typically paid by the owner in multifamily properties, particularly when there is a single water meter.
A conservative estimate of $14,000 per year is used here. Landscaping and gardening services are estimated at $1,800 annually.
Maintenance is another commonly underestimated expense. Allocating a consistent monthly reserve helps account for repairs and wear across multiple units.
Using an average of $500 per month results in an annual maintenance expense of $6,000.
Trash services add approximately $3,000 per year, and required city business licensing fees add an additional $300 annually.
When all operating expenses are combined, the total annual expenses for this property equal $89,823.
Step Three: Calculating Net Operating Income (NOI)
With adjusted rental income of $211,948 and total operating expenses of $89,823, the net operating income is calculated by subtracting expenses from income.
The resulting NOI is $122,125.
This figure represents the true income generated by the property before financing and tax considerations and serves as the foundation for calculating the cap rate.
Step Four: Determining the Cap Rate
To calculate the cap rate, the net operating income is divided by the purchase price of the property.
$122,125 ÷ $2,950,000 results in a cap rate of approximately 4.14%.
In the context of an 11-unit multifamily property located in Hawthorne, California, this cap rate falls within a reasonable range for a well-performing asset.
Market conditions, property quality, rent control policies, and neighborhood demand all influence what is considered an acceptable cap rate, and these factors must always be evaluated together.
Using Cap Rate as a Decision-Making Tool
Cap rate should never be analyzed in isolation. It works best when combined with other performance metrics such as gross rent multiplier, cash-on-cash return, and long-term appreciation potential.
Together, these indicators help investors determine whether a property is priced fairly and aligns with their investment strategy.
Whether you are evaluating a sale price, considering a 1031 exchange, or analyzing a new acquisition, understanding how to calculate and interpret cap rate gives you greater control over your investment decisions and reduces reliance on assumptions or incomplete data.