Investing in residential real estate requires knowledge of specific metrics. Two crucial metrics savvy real estate investors use to determine the financial aptitude of a prospective purchase are Net Operating Income (NOI) and Capitalization Rate (Cap Rate). They are always annual rates and they are related. So what are NOI and Cap Rate?
You first calculate the NOI, then you can determine a property’s Cap Rate. Let’s look at each step and use an example property. Once you understand the steps, you can take this same template and use it to evaluate prospective real estate investments in your area.
Calculating Net Operating Income (NOI)
1. Calculate the 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. Let’s look at an example of a quad where each unit rents for $1,000.
4 units X $1,000/month = $4,000/month.
$4,000/month X 12 = $48,000/year.
2. Subtract for vacancy and rent loss (un-rented units and unpaid bills).
Let’s assume that two of the units are vacant for one month on an average year. That’s about a 4 percent vacancy rate or a 96 percent occupancy rate.
$48,000/yr X 96 percent = $46,080
3. Add 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.
$46,080/yr + $3,600/yr = $49,680/yr.
This is your Effective Gross Income (EGI).
4. Subtract expenses from Effective Gross Income.
There are three categories of expenses:
1. Fixed: Property Tax, Insurance, etc. You pay these whether the unit is rented or not.
2. Operating: In this category are: Utilities, property manager, advertising, lawn care, pest control, minor repairs, and so forth.
3. 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.
5. Calculate Net Operating Income by subtracting expenses from Effective Gross Income.
$49,680 (EGI) – $10,000 (Fixed) – $4,000 (Operating) – $3,000 (Reserve) = $32,680
Your NOI = $32,680
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 the business.
6. Cash Flow = NOI – Mortgage Payment
To calculate cash flow, subtract your mortgage payment from net operating income.
7. Next you need to calculate Cap Rate.
Calculating Cap Rate
1. To calculate 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 Rate.
2. Divide NOI by the sale price. This is the Cap Rate.
$32,680 / $500,000 = 6.5 % Cap Rate.
Depending on the economy and the local market, you need to decide if a yield of 6.5 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.
3. Here is another way of looking at the problem: NOI / Cap Rate = VALUE.
If you are looking for an 6.5 percent yield, then you would calculate the maximum you would pay for the building with the following formula:
$32,680 / 6.5 % = $507,769 or rounded off, $508,000. Your purchase offer would be no more than $508,000. As Cap Rate goes up, Value goes down.