Short answer
Cap rate is a property's net operating income divided by its price or value. In western North Dakota, a good cap rate is not a fixed figure. It is one that still meets your minimum when you recalculate it with downturn rent and longer vacancy, because a high cap rate here is mostly payment for the risk of the energy cycle. Build the net operating income from real expenses, not a seller's projection, before comparing it to anything.
Ask what a good cap rate is and you will get a range, usually with a caveat that it depends on the market. That caveat is the whole answer in western North Dakota. A cap rate that looks generous next to a large metro can be thin here once you price in what the energy cycle does to rent and vacancy, and a cap rate quoted by a seller is often calculated in a way that makes the property look better than it will perform.
This guide covers how to calculate cap rate on a rental property, the mistakes that inflate it, and a simple stress test that tells you whether a western North Dakota cap rate is actually good. It goes deeper on one metric than our article on rental property cash flow vs profit, which explains how cap rate, cash on cash return and accounting profit fit together.
What cap rate measures, and what it does not
Cap rate, short for capitalization rate, is the annual net operating income a property produces divided by its price or current value.
Cap rate = net operating income ÷ purchase price (or current value)
Because it leaves out financing, cap rate describes the building rather than your deal. Two investors who buy the same fourplex, one with cash and one with a large mortgage, will see the same cap rate and very different returns on the money they put in. That is what cap rate is for: comparing properties to each other on equal terms, before anyone's loan gets involved.
It does not tell you:
- Your return on cash invested. That is cash on cash return, which depends on your down payment and loan.
- Appreciation. Cap rate is a snapshot of income, not a forecast of value.
- Whether the income will last. This is the gap that matters most in the Bakken, and the reason for the stress test later in this article.
How to calculate cap rate on a rental property
The division is easy. The work is in the net operating income, and that is where most cap rates go wrong.
Step 1: Start with gross scheduled rent
Multiply the monthly rent by twelve, for every unit, as if each one were leased all year. Use rent the unit can achieve now, based on comparable units that have actually leased recently. Our guide to rental comps in western North Dakota covers how to build that figure when automated estimates fall short.
Step 2: Subtract vacancy to get effective income
No unit is leased every day of the year. Subtract the rent you expect to lose between tenants. In this market, vacancy depends heavily on pricing and season, which our article on how long it takes to rent a house in western North Dakota walks through. Leaving vacancy at zero is the single most common way a cap rate gets inflated.
Step 3: Subtract operating expenses to get net operating income
Operating expenses are the costs of running the property:
- Property management fees
- Leasing or tenant placement fees each time a unit turns over
- Property taxes
- Insurance
- Maintenance and repairs
- Utilities the owner pays, including heat, snow removal and lawn care while a unit is vacant
Net operating income does not include your mortgage payment, depreciation or income taxes. Those belong to your financing and your tax situation, not the building.
Capital reserves for roofs, furnaces and water heaters are a judgment call. Many investors leave them out of net operating income and account for them separately. Whichever you choose, do it the same way for every property you compare, or the comparison means nothing.
Step 4: Divide by price or value
Divide net operating income by the purchase price if you are buying, or by a realistic current value if you already own the property.
A worked example: a Williston single-family rental
The figures below use the $1,800 a month Williston rental, the 10% management fee and the 75% placement fee from our article on what property management costs in North Dakota. The purchase price, taxes, insurance, maintenance and utility figures are illustrative assumptions to show the method. Use your own numbers.
| Line | Annual amount |
|---|---|
| Gross scheduled rent ($1,800 × 12) | $21,600 |
| Less vacancy (one month) | $1,800 |
| Effective income | $19,800 |
| Management at 10% of rent collected | $1,980 |
| Placement fee at 75% of one month's rent | $1,350 |
| Property taxes (assumed) | $3,000 |
| Insurance (assumed) | $1,500 |
| Maintenance and repairs (assumed) | $1,800 |
| Utilities and snow removal while vacant (assumed) | $400 |
| Total operating expenses | $10,030 |
| Net operating income | $9,770 |
At an illustrative purchase price of $120,000, the cap rate is $9,770 ÷ $120,000, or about 8.1%.
Why a seller's cap rate usually runs high
Now calculate the same property the way it often appears in a listing: no vacancy, no management fee and no placement fee, because the current owner manages it themselves and the tenant has been there for years.
| Line | Seller's version | Realistic version |
|---|---|---|
| Effective income | $21,600 | $19,800 |
| Operating expenses | $6,700 | $10,030 |
| Net operating income | $14,900 | $9,770 |
| Cap rate at $120,000 | 12.4% | 8.1% |
Same house, same price, and the advertised cap rate is more than four points higher. Nothing in the seller's version is necessarily dishonest. It describes the past under one owner's circumstances. It does not describe what you will earn if you have to pay for management, fill a vacancy or replace a long-term tenant.
Before trusting any quoted cap rate, ask for:
- The actual rent collected over the last twelve months, not the scheduled rent
- How long each unit sat empty in that period
- The real expense records, including repairs and owner-paid utilities
- Whether the figure includes a management fee, even if the seller does not pay one
What makes a cap rate good in western North Dakota
The cap rates quoted as typical in national articles are drawn from markets where rent moves slowly with population and employment. Western North Dakota does not work that way. The same house can rent for meaningfully different amounts at different points in the energy cycle, and vacancy can stretch quickly when activity slows.
That changes what a high cap rate means. Here, a cap rate that looks generous is largely payment for that risk. It is only a good cap rate if the property still earns enough when conditions turn against you.
The stress test
Recalculate net operating income with a hypothetical downturn: lower rent and a longer vacancy. The figures below are an illustration of the method, not a forecast.
| Line | Current conditions | Hypothetical downturn |
|---|---|---|
| Monthly rent | $1,800 | $1,500 |
| Months vacant | 1 | 2 |
| Effective income | $19,800 | $15,000 |
| Management at 10% | $1,980 | $1,500 |
| Placement fee at 75% of one month | $1,350 | $1,125 |
| Taxes, insurance and maintenance | $6,300 | $6,300 |
| Utilities and snow removal while vacant | $400 | $600 |
| Net operating income | $9,770 | $5,475 |
| Cap rate at $120,000 | 8.1% | 4.6% |
Notice what does not move. Taxes, insurance and maintenance stay the same when rent falls, so a drop in income comes almost entirely out of net operating income. A property that looks like an 8% cap rate today behaves like a 4.6% cap rate in this downturn.
So the useful question is not whether 8% is good. It is whether you can live with the downturn figure. Decide your own minimum before you look at listings, and judge every property by its stress-tested cap rate, not its headline one.
What a narrow gap tells you
Run the stress test on several properties and compare how far each one falls. A property whose cap rate drops less in a downturn usually has one or more of these:
- Rent that is already modest for the area, so there is less room to fall
- Unit types and locations that stay in demand across the cycle
- Lower fixed costs relative to rent
- A history of short vacancies that you can verify with records, not assurances
Those properties often show a lower headline cap rate than riskier ones. That is the market pricing the difference, and it is often the better buy.
How cap rate connects to value
Rearrange the formula and it tells you something useful about properties you already own:
Value = net operating income ÷ cap rate
At an 8% cap rate, every $1,000 of additional net operating income adds about $12,500 of value, because $1,000 ÷ 0.08 = $12,500. Every $1,000 lost does the opposite. That is why vacancy, turnover and unchecked repair costs matter beyond this year's cash flow. They lower net operating income, and buyers and lenders price the property from net operating income.
It also works in your favor. A shorter vacancy, a renewal instead of a turnover, or a repair caught before it becomes a replacement all raise net operating income, and with it the value of the property.
Cap rate, cash on cash return and ROI
Cap rate is one of three numbers investors use, and they answer different questions:
- Cap rate compares buildings, ignoring financing.
- Cash on cash return measures what your invested cash earns each year after the mortgage.
- Total return, sometimes called ROI, adds appreciation and loan paydown over time.
A property can look strong on one and weak on another, so always say which you mean. Our article on cash flow vs profit works through all three on the same property, along with why depreciation makes your tax return and your bank balance disagree.
Questions to ask before you rely on a cap rate
Whether the figure comes from a seller, a listing agent or your own spreadsheet, these questions separate a real cap rate from a hopeful one:
- Is this based on rent actually collected, or on scheduled rent?
- What vacancy is assumed, and how does that compare with how long similar units in this town have actually taken to lease?
- Does it include a management fee and a placement fee, even if the current owner pays neither?
- Which expenses are actual records and which are estimates?
- Are capital reserves included or excluded?
- What is the cap rate at a lower rent and a longer vacancy?
If a property manager is helping you evaluate a purchase, ask them for the inputs rather than the conclusion: what comparable units are leasing for now, how long they sit between tenants, and what maintenance has actually cost on similar properties.
Get the inputs from someone who tracks them locally
The formula is the easy part. The inputs are what make a cap rate honest, and in western North Dakota they change with the cycle. Bakken Property Management manages rental homes across western North Dakota, and we can share what comparable units are actually leasing for and how long they take to fill. If you are weighing a purchase or want a clearer picture of a property you already own, get in touch.
