Net Operating Income (NOI)
Understanding the Capitalization Rate Formula
The Capitalization Rate, or "Cap Rate," is one of the most fundamental metrics in real estate investing. It allows investors to assess the profitability and return potential of an investment property independent of its financing. Unlike cash-on-cash return, the cap rate assumes the property is purchased entirely with cash, providing a raw measure of the asset's yield.
The Core Formula
Cap Rate = (Net Operating Income / Current Market Value) × 100
How to Calculate Cap Rate
To use the capitalization rate formula effectively, you must understand its two primary components: Net Operating Income (NOI) and Property Value.
1. Determine Net Operating Income (NOI)
NOI is the total income a property generates after all operating expenses are paid, but before taxes and mortgage payments. This is a critical distinction—debt service is never included in a Cap Rate calculation.
- Gross Income: Include all rental income, parking fees, laundry coin-op revenue, and other service charges.
- Operating Expenses: Subtract property management fees, property taxes, insurance, repairs, maintenance, utilities, vacancy reserves, and landscaping.
- Do Not Subtract: Mortgage principal, mortgage interest, or capital expenditures (major renovations).
2. Determine Property Value
This is either the current asking price (if you are looking to buy) or the current appraised market value (if you already own the asset). Using the Cap Rate helps determine if the asking price is justified based on the income the property generates.
Real World Example
Let's assume you are analyzing a small apartment complex with the following numbers:
- Purchase Price: $1,000,000
- Gross Annual Rents: $120,000
- Operating Expenses (Taxes, Insurance, Maintenance): $40,000
First, calculate the NOI:
$120,000 (Income) – $40,000 (Expenses) = $80,000 (NOI)
Next, divide by the Purchase Price:
$80,000 / $1,000,000 = 0.08
Finally, multiply by 100 to get the percentage:
Cap Rate = 8.0%
What is a Good Cap Rate?
There is no single "good" Cap Rate, as it varies significantly by location and asset class. However, general guidelines suggest:
- 4% to 5%: Common in high-demand "Class A" areas (like downtown NYC or San Francisco). These properties are lower risk but offer lower immediate returns.
- 6% to 8%: Often considered a healthy balance of risk and return for residential multifamily properties in stable suburban areas.
- 10%+: Often found in riskier neighborhoods or rural areas where the potential for vacancy or extensive maintenance is higher.
Why Use This Calculator?
This calculator helps you strip away the noise of financing terms. By focusing purely on the relationship between income and price, you can compare a $200,000 single-family home against a $5,000,000 commercial building on an "apples-to-apples" basis. If the Cap Rate is lower than the prevailing interest rate for mortgages, the property may result in negative leverage, meaning you would lose money by borrowing to buy it.