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Real Estate Investing: What are NOI and Cap Rate?

by | Jul 8, 2019

Investing in real estate can be lucrative. With careful market research and due diligence, there are ample opportunities for real estate investment to become a profitable and ongoing income. The key is to turn real estate investment from a hobby into a business. This means being strategic and measured in your approach. 

There are many business terms and practices that you must be aware of in order to be a successful real estate investor. Here we are going to discuss two terms that are crucial to your investment knowledge; NOI and Cap rate.

What is NOI?

NOI stands for net operating income, and is colloquially known as “NOI.” It is a calculation that can be used to analyze the profitability of a real estate investment. Net operating income is the sum of all revenue received from the property minus all necessary operating expenses.

It is important to remember that NOI is a before-tax figure, and it excludes the principal as well as the interest payments on loans. It is also kept separate to other capital expenditures and depreciation related to the property. 

To calculate the net operating income, you must adhere to the following formula;

Net operating income = Real Estate Revenue – Operating Expenses

It is important to note that properties can generate income other than rent, such as parking fees or vending and laundry fees. 

There are also several operating expenses that should be considered when renting a property such as the costs of maintaining the building and the property, as well as insurance, property management fees, utilities, property taxes,  janitorial fees and any repairs that may be necessary. It is crucial to remember that if the building also requires a capital expenditure such as replacing the air-conditioning system, this is not included in the calculation. 

Net operating expenses can also be used to determine the capitalization rate. The capitalization rate helps to determine a property’s value and can also help investors to compare potential investment properties that they may be considering.

What is the cap rate?

The cap rate, also known as the capitalization rate, indicates the rate of return that is expected from a real estate investment property.

Although there are several ways to measure investment return, the cap rate is the most popular measure to assess profitability and potential. Put simply, the capitalization rate measures the yield of a property over the space of a year and indicates the property’s intrinsic and unleveraged (without a loan) rate of return.

You can use several methods to compute the capitalization rate; however the most straightforward formulae is calculated by dividing the property’s net operating income (NOI) by the current market value. 

For example:

Net Operating Income / Current Market Value = Capitalization Rate 

Although the cap rate can be useful as a quick method to compare the relative value of a real estate investment, it is not a fool-proof indicator of an investment’s strength. This is because it does not take into account leverage, for example, if you have to borrow to purchase the property, or future cash flows from any property improvements that you may make. 

It is also important to remember that there are no definitive ranges that a good or bad cap rate falls in to. This depends on the type of property as well as the market that the property is located. It is crucial that if you’re considering investing in real estate that you research the market as well as considering the quantitative measures as a decision making factor.

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