Cap Rate (or Capitalization Rate) is a real estate valuation measure that gives a quick benchmark as to a property’s value. Cap Rate is often calculated as the ratio between the Net Operating Income (NOI)* to property value or sales price at a given point in time.
Calculate the Cap Rate by dividing the Net Operating Income (NOI) by the sale price or value of a property (cap rate = net operating income/property value).
The lower Cap Rate usually comes with lower risk but at a higher price for the investment property.
To calculate the market value of a property, divide the net income by the cap rate (Net Income/Cap Rate=Market Value).
Net Operating Income (NOI)
NOI is the annual income generated by an income-producing property after collecting all income from operations, such as rentals and other uses of the property by others, and deducting all expenses required to operate the property. The assumptions and judgments made in calculating NOI affect the decision to invest in a given property and at what price. Lenders use NOI to determine the loan amount, investors to determine what they will pay, and appraisers to determine market value.
The four basic components of NOI are:
- Potential rental income (PRI)
- Vacancy and credit losses
- Other income
- Operating expenses
Calculate NOI by using the following model:
Income Potential Rental Income − Vacancy and credit losses = Effective Rental Income + Other Income (collectible) = Gross Operating Income − Operating Expenses = Net Operating Income (NOI)