When considering a real estate purchase, it is essential to understand the terms and measurements that are commonly used to evaluate the property’s performance and value. Two key terms to get acquainted with are NOI and cap rateThe capitalization rate, or cap rate, is one of the most widely-used metrics for estimating the yiel....
NOI (an acronym for net operating income) provides a thumbnail picture of how much net income a property earns. It is calculated using the following formula:
NOI = Real Estate Revenue or Income – Operating ExpensesOften referred to as “OpEx,” operating expenses refer to all costs necessary to operate and main...
Because of its simplicity, NOI is difficult to manipulate and is often relied on to rank the relative financial strength of the property. It is also used to calculate other measures such as cap rate, debt service coverage ratio (DSCR)The DSCR is a tool used to underwrite a loan secured by an income producing property. The ratio is c..., and return on investment (ROI).
The cap rate (short for capitalization rate) represents the yield an owner can expect on an investment property and is calculated with this formula:
Cap Rate = Net Operating Income (NOI)The revenue a property earns minus operating expenses, vacancy, and uncollectible receivables.
Current Market Value
Cap rates are often used to measure the risk of an investment property. A low cap rate, relative to other similar properties, is typically associated with less risky investments. A high cap rate in the same context could imply a riskier investment.
The variables inside this calculation can often change. For instance, if a property increases in value while maintaining the same NOI, its cap rate will decrease— a process known as cap rate compression. If the NOI increases while the property maintains or lessens its current value, the cap rate will go up.
While cap rate and NOI are just two of many variables to review, they can be instrumental in evaluating the value of a property and whether or not it is the right investment for you.