Valuation by capitalization and the cap rate

Capitalizing income

Direct capitalization estimates an income property's value from one year's stabilized net operating income, or NOI, and a market-supported capitalization rate. The relationship is Value = NOI / capitalization rate. Use the rate as a decimal.

NOI is effective gross income minus operating expenses. Start with potential gross income, subtract vacancy and collection losses, and add other property income to find effective gross income. Deduct operating expenses such as property taxes, insurance, management, and ordinary repairs. NOI is calculated before mortgage debt service and income taxes; accounting depreciation is not an operating expense in this calculation. Do not substitute gross rent or cash flow after debt service for NOI.

Work the relationship

If the stated annual NOI is $120,000 and the cap rate is 8%, convert 8% to 0.08. Then $120,000 / 0.08 = $1,500,000. The stem already gives NOI, so do not subtract operating expenses again.

Rearrange the same relationship to find cap rate = NOI / value or NOI = value × cap rate. A comparable property with annual NOI of $90,000 and a $1,200,000 sale price indicates $90,000 / $1,200,000 = 0.075, or 7.5%. A property valued at $800,000 at 6% implies $800,000 × 0.06 = $48,000 annual NOI.

Interpret the cap rate

Holding NOI constant, a higher cap rate produces a lower value; a lower cap rate produces a higher value. Holding the cap rate constant, higher NOI produces higher value in direct proportion. Compare properties using consistent income and expense assumptions. Similar market sales help support a cap rate; differences in risk, location, condition, tenancy, and growth expectations affect comparability.

A cap rate relates property income to the property's price or value. It is not the mortgage interest rate, a gross rent multiplier, or cash-on-cash return on the buyer's equity. Greater perceived risk generally supports a higher required cap rate, other factors equal. Direct capitalization is an estimate dependent on sustainable income and a suitable rate, not a promise of future investment performance.