Understanding Cap Rate and Net Operating Income 

What is capitalization rate and net operating income? 
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‍Capitalization rate, also known as cap rate, is the rate of return on a real estate investment based on the net operating income (NOI) that the property is generating. This can be calculated using the formula: 
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               Cap Rate = NOI / Market Value

One must understand what cap rates are trading for in order to implement this equation. Numerous factors play a role in the capitalization rate, including both the market and the area. As market conditions decline, the cap rate increases and vice versa. That being said, the market value is inversely related to the cap rate. There would therefore be an increase in property value if the cap rate were to decrease, assuming the NOI stayed the same. 

The cap rate, however, is not the only variable affecting market value that can fluctuate. NOI is positively related to the value of a property and can be defined by the income generated by a property less all operating expenses.

Let’s take an example investment with an NOI of $1,000,000 and a cap rate of 5%. By manipulating the cap rate equation above, we are able to determine a market value of $20,000,000 as shown below: 

               NOI / Cap Rate = Market Value 
               $1,000,000 / .05 = $20,000,000
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How do you utilize the cap rate and net operating income in your investment strategy?

‍Now that we understand both factors influencing the market value of a property, how do we utilize this when determining our investment strategy? If we were to buy a property today with the plan to exit in 3-5 years, we must make an educated guess on what the cap rate will be at the time of sale. When making this educated guess, typically this number will be less advantageous than the cap rate we are at today for the purpose of being conservative. Other than being conservative with this guess, there is little an investor can do when it comes to determining the role the cap rate plays in the market value of a property as you are not able to predict the future.

On the other hand, implementing a strategic business plan in order to increase NOI has a large potential to increase the market value. There are two ways to achieve this - increasing income and/or decreasing expenses. When searching for an investment opportunity, we seek properties with the most opportunities for increasing income. This may include things such as making updates, adding units, bringing rent up to market rental rates, etc. 

Decreasing operating expenses plays a major role in increasing NOI as well. Roughly speaking, for each dollar made in gross income, about 50% goes to expenses. Limiting operating expenses consequently increases NOI more so than increasing income since there is no percentage loss on each dollar saved. In other words, for each dollar generated by increasing income, approximately 50 cents will contribute to the NOI. Every dollar saved by improving expenses, however, is a dollar added to the NOI. That being said, expenses must be strategically cut where it is beneficial to do so, as we must maintain proper operation of the property. 

When considering investing in real estate, be sure that you not only understand the cap rate but everything behind each component of the equation as well. In doing so, an investor is able to utilize this when evaluating an investment property or implementing a business plan to determine the best investment strategy. Use these equations to compare investments side by side in the future and be sure you understand where the opportunity is before you choose to invest!

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