NOI vs. Cap Rate — What's the Difference?

If you're looking to buy real estate investment property, you'll need to know how to calculate the NOI and cap rate, as these metrics help determine whether a rental property will be a good investment. They apply across all real estate niches, including residential and commercial real estate property.

In this guide, we'll break down NOI and cap rates and provide step-by-step instructions on how to calculate them. Mastering these metrics will better equip you to evaluate your next real estate investment.

We'll also explore additional factors that, while not directly part of the NOI and cap rate calculations, can significantly impact the overall profitability of an investment property. With this knowledge, you'll be able to make decisions that match your financial goals and shape your real estate investment strategy for success.

What is NOI?

Net operating income (NOI) is a metric used to analyze the profitability of income-generating real estate investments. It's a measurement of a property's financial performance after deducting all reasonably necessary operating expenses. A positive NOI shows that the property generates more income than its operating expenses.

The NOI formula

To calculate net operating income, subtract operating expenses from gross operating income:

NOI = Gross operating income - Operating expenses

Gross operating income

Gross operating income is the total revenue generated from the property before deducting any expenses. For example, charging $2,000 in monthly rent leads to an annual potential rental income of $24,000.

Adjust for vacancy rates to reflect times when the property might be unoccupied. If the vacancy rate is 5%, you'd experience a loss of income of $1,200 due to vacancies, which yields a gross operating income of $22,800.

Operating expenses

Operating expenses are comprised of all of the costs associated with maintaining and managing the property, including:

• Property taxes.
• Insurance premiums.
• Utilities (electric, gas, water).
• Repair and maintenance costs.
• Property management fees.
• Janitorial/cleaning fees.

What the NOI calculation doesn't include

There are other investment property costs and expenses that are not part of the NOI calculation. These include:

Capital expenditures

Capital expenditures, such as major renovations, improvements, or other significant investments like a new roof or HVAC system overhaul, do not get included in the NOI calculation. These are large, one-time investments that enhance the property's value or extend its useful life, not regular operational costs.

Excluding these costs from the NOI calculation helps provide a more accurate representation of the property's regular income-generating ability. It avoids skewing the operational cash flow with expenses that do not reflect the day-to-day operations, offering a clearer picture of the property's ongoing profitability.

Depreciation

Depreciation is an accounting function used to spread out the cost of a tangible asset over its useful life for tax purposes. It reflects the gradual wear and tear or obsolescence of real estate property over time.

Even though it's key for overall profitability and tax planning, depreciation isn't an actual cash expense related to the property's operations. Excluding it from the NOI calculation prevents underestimating the property's operational cash flow, offering a more accurate reflection of its income-generating potential.

Income taxes

Property owners and investors exclude income taxes from operating expenses. Income taxes relate to the overall profitability of the investment or business entity, not merely to the operations of one property.

Income taxes depend on net income from all sources. Excluding income tax liabilities from the NOI calculation allows a focus on the property's operational performance and avoids double-counting of taxes paid on other income sources.

Mortgage amortization

Mortgage payments, including principal and interest payments, are not operating expenses. These payments are associated with the property's financing and ownership, not its daily operations.

They represent the cost of borrowing money to buy or refinance the property and depend on the loan amount, interest rate, and payment schedule. Excluding mortgage payments from the NOI calculation allows investors to evaluate the property's income-generating capability regardless of its financing setup. This leads to a fair comparison of real estate properties with different financing or ownership structures.

Calculating NOI

Let's consider an example of an NOI calculation:

Suppose you have a property that generates $100,000 in rent, representing its gross operating income. The yearly operating expenses break down as follows:

• Property taxes: $10,000
• Insurance: $5,000
• Utilities: $8,000
• Repairs and maintenance: $7,000
• Property management fees: $6,000

When added together, this leads to total operating expenses of $36,000.

To calculate the NOI, subtract these operating expenses from the gross operating income:

NOI = Gross operating income ($100,000) - Operating expenses ($36,000)

The investment property NOI is = $64,000.

What is a good NOI?

There is no definitive benchmark for a "good" NOI, as it depends on different factors, such as the property type, location, and market conditions.

A higher NOI indicates a more profitable property, because it generates more income after deducting operating expenses. Real estate investors often assess NOI when evaluating the property's value or purchase price to gauge its potential return on investment.

What is the cap rate?

The capitalization rate, commonly known as the cap rate, is another financial tool that real estate investors and property owners use. It's a way to evaluate potential investments or assess the value of existing properties.

You calculate it by dividing the property's NOI by its current market value:

Cap rate = Net operating income (NOI) / Current market value of the asset

Cap rate example calculation

Let's consider the following example:

Imagine a property with an NOI of $80,000 and a market value of $1,000,000. The cap rate calculation would look like this:

Cap rate = NOI / Current market value of the asset

Cap rate = $80,000 / $1,000,000

Cap rate = 0.08 or 8%

The importance of the capitalization rate

The cap rate helps investors compare different real estate investments by showing the potential return as a percentage of the property's value. This provides comparisons across properties with different income levels and prices.

The cap rate also signals the level of risk and potential return. Higher rates suggest increased returns and risk, while lower rates point to reduced risk and potential gains. Preferences for rates vary among investors based on their tolerance for risk and desired returns, with some seeking higher risks for greater rewards and others choosing safer, lower-return options.

While cap rate is a useful way to compare investments quickly, don't base your decisions on this alone. Consider factors like property condition, local market trends, potential changes in value, and how it fits with your overall investment plan and risk tolerance.

Implied cap rate vs. actual cap rate

Relying too much on capitalization rates can be risky, because the actual rental income may differ from projections due to vacancies, market changes, or recessions. Be aware of the difference between the implied and actual cap rates.

• Implied cap rate: This represents the expected return on an investment. You calculate it by dividing the projected stabilized first-year NOI by the purchase price. Forecasted earnings and the seller's asking price form its basis.
• Actual cap rate: This reflects the real return on your investment. You determine it by using the trailing 12-month historical NOI and the actual sale price received. This rate provides a true reflection of the return after owning the property.

The disparity between these rates highlights the risk of relying solely on projections. The implied cap rate aids in assessing potential investments, and the actual cap rate offers insight into the genuine returns realized.

What is considered a good cap rate?

A "good" cap rate is subjective. Most investors tend to look for a cap rate in the 8-12% range as a starting point. Generally speaking, a cap rate that generates strong cash flow relative to the purchase price will likely be a good property investment.

The higher the NOI and the lower the property's value or price, the higher the cap rate will be. While a low cap rate may not seem great, it could still be appealing for institutional-grade properties located in prime areas, representing stable and low-risk investments.

Cap rate expansion vs. cap rate compression

Real estate investing is always changing, with different factors impacting the market. One major factor is the cycle of cap rates. When rates go up or down, it creates a ripple effect through the whole market.

• Cap rate expansion: This occurs when cap rates increase, indicating that investors perceive higher risk in the market. They demand higher returns to compensate for this increased risk, which often leads to a decrease in real estate property values.
• Cap rate compression: This happens when cap rates decrease, reflecting a more optimistic outlook from investors. They're willing to accept lower returns relative to the perceived risk, leading to an increase in property values as the rates decline.

Cap rate vs. NOI

When evaluating real estate investments, don't overlook the importance of net operating income and the cap rate formula. They each offer different information, but together, they help you understand how a property performs and what kind of returns you could potentially make.

It's not just about crunching numbers, though. Consider a wide range of factors to fully understand an investment's value. Successful real estate investing means analyzing data smartly to make purchase decisions. Mastering NOI and cap rate is a big part of that process. Keep them in mind as you evaluate deals, and you'll be on the path to success in real estate!

Cap rate and NOI FAQs

What is the relationship between cap rate and NOI?

Cap rate and NOI are directly connected. A higher NOI compared to the property's value means a higher cap rate, while a lower NOI relative to the property's value results in a lower cap rate.

What does a 7.5% cap rate mean?

A 7.5% cap rate implies that the annual rental income from a property is 7.5% of its purchase price. For example, if you purchase a property for $1 million at a 7.5% cap rate, you can expect $75,000 in rental income each year, not including mortgage expenses.

What is the difference between cap rate and ROI?

The cap rate measures the property's yield solely based on income, while ROI (return on investment) considers financing costs, equity invested, and any changes in the property's value over time.