What is a cap rate? The formula, with a worked example

What is the cap rate formula?

Cap rate = NOI ÷ price (or value)

Turned around, it gives a value: value = NOI ÷ cap rate. The OCC’s Comptroller’s Handbook calls this direct capitalization: it “estimates the value of a property by capitalizing the NOI using an appropriate capitalization rate,” which “is accomplished by dividing the NOI by the capitalization rate.” Appraisers and lenders use it as part of the income approach to value, which converts expected future NOI into a present value.

What is net operating income?

The OCC glossary defines NOI as annual gross income less operating expenses:

• Gross income is all income the property produces: rents, plus other income such as parking fees, laundry and vending. Tenant reimbursements can be included if the matching expenses are counted as operating expenses.
• Vacancy. For underwriting, the analysis starts from the income the property would earn fully leased, then applies a vacancy factor to get the effective gross income.
• Operating expenses are the costs of running and normally maintaining the property. They include a replacement reserve for capital items, which is counted for underwriting whether or not it is actually funded.

What does NOI leave out?

Under the OCC definition, operating expenses do not include:

• Interest and principal, so your mortgage payment (debt service) is not in NOI;
• Income taxes;
• Depreciation and capital items (a replacement reserve is counted instead).

That is why two buyers of the same building see the same NOI and cap rate even if one pays cash and the other borrows. Lenders look at the loan separately, for example with the debt service coverage ratio (DSCR), which the OCC defines as NOI divided by annual debt service.

A worked example

The figures below are hypothetical, chosen to show the arithmetic. They are not market rates for any city or property type.

A four-unit rental building is offered for $600,000.

• Cap rate at the asking price: $36,000 ÷ $600,000 = 6.0%.
• Value at a different cap rate: if you apply 7% to the same NOI, $36,000 ÷ 0.07 = $514,286. A higher cap rate on the same income means a lower value.
• The loan is separate: if the mortgage costs $30,000 a year, NOI is still $36,000. The DSCR is $36,000 ÷ $30,000 = 1.2.

What are the limits of a cap rate?

• It assumes stable income. The OCC says direct capitalization is appropriate when it is applied to a stabilized NOI and the future income stream is expected to be stable. For a property that is not yet leased up, or whose income is expected to swing, the handbook points to a discounted cash-flow analysis instead. The FDIC’s examination manual says the same: direct capitalization is often used when market conditions are stable, and discounted cash flow is more typical for troubled properties.
• It is one year of income. It does not show rent growth, a large repair coming due, or what you could sell for later.
• The NOI must be built the same way. Two listings quoting “6%” can mean different things if one leaves out vacancy or the replacement reserve. Rebuild the NOI yourself from the rent roll and the expense bills.
• It moves with interest rates. The OCC notes that rising interest rates may lead to higher cap rates and lower property values without any change to the property itself.
• It ignores your taxes and financing. Your actual return depends on your loan, your income tax and depreciation, none of which are in NOI.

There is no official national or “average” cap rate. Cap rates depend on the market and the property type, so compare a building with recent sales of similar properties nearby, and ask the appraiser which rate was used and why.

Where states differ

The formula is the same everywhere, but two of the largest operating expenses are set locally. Property tax depends on your county’s rate and assessment: see states with the lowest property tax. Insurance premiums vary widely by state and by risk: see home insurance costs by state. If you sell one rental to buy another, a 1031 exchange may defer the tax on the gain.