NOI & Cap
Of the various measures to determine the
financial aptitude of a prospective purchase, two measures stand out:
Net Operating Income (NOI) and Capitalization Rate (Cap Rate).
They are always annual rates and they are related. Cap Rate
builds on NOI.
rent as if every unit is always rented at the
fair market rent for
one year. This is your potential gross rent or
potential gross income.
apartment units X $425/month =
$10,200/month. $10,200/month X
12 = $122,400/year.
Subtract for vacancy and rent
loss (un-rented units and unpaid bills). Let's
assume that for one reason or another, only 90 percent
of the units are rented at any point in time. That
is a 10 percent vacancy rate or a 90 percent
$122,400/yr X 90 percent =
miscellaneous income. This can come from parking
garage charges, coin operated washing machines or
vending machines, for example. Let's assume you
receive $300/month from these sources, or $3,600/year.
+ $3,600/yr = $113,760/yr. This
is your Effective Gross Income (EGI).
expenses from Effective Gross Income. There are
three categories of expenses:
FIXED -- Property Tax,
Insurance, etc. You pay these whether the unit is
rented or not.
OPERATING -- In this
category are: Utilities, property manager,
advertising, lawn care, pest control, minor repairs, and
RESERVE -- This is money
put aside for anticipated future major repairs or
replacements, such as a roofs, boilers or refrigerators.
This category is often omitted in
pro forma documents,
but should be present as a pro rated expense.
Operating Income by subtracting expenses from Effective
EXAMPLE: $113,760 (EGI) - $11,400
(FIXED) - $16,000 (OPERATING) -
$3,300 (RESERVE) = $83,060
Your NOI =
NOTE: Do not use the
mortgage payment or the interest in computing NOI, as
these are expenses of the buyer and not the property or
Cash Flow =
NOI - Mortgage Payment
calculate Cap Rate. See the next chart.
CALCULATING CAP RATE
the Capitalization Rate, you will need the sale or
purchase price of the property and the NOI, which you
just calculated. You can view Cap Rate as the
annual rate of profit. If you bought a Certificate
of Deposit with a 5 percent annual yield, the Cap Rate
would be 5 percent. Similarly, owning an income
producing property has a predictable annual yield or Cap
Divide NOI by the sale price.
This is the Cap Rate.
EXAMPLE: $83,060 /
$940,000 = 8.8 percent Cap Rate.
Depending on the economy and the local market, you need
to decide if a yield of 8.8 percent makes good financial
sense. In other words, would owning a Certificate
of Deposit yield you a similar income, or would you make
more money owning real estate? In this example,
the real estate is the better value. Also, keep in
mind that most real estate will appreciate in value each
year, typically 3 to 4 percent, again depending on the
area and the market.
another way of looking at the problem: NOI /
Cap Rate = VALUE
If you are looking for an 9.0
percent yield, then you would calculate the maximum you
would pay for the building with the following formula:
/ 9 percent = $922,888 or rounded off,
$923,000. Your purchase offer would be no more
than $923,000. As Cap Rate goes up, Value goes