Understanding NOI/Cap Rate & How to Calculate Them

NOI and cap rate are used to analyze the profitability of real estate investment. Read to learn how NOI/cap rate work and how to calculate them.

Real estate investments are one of the most popular forms of investment vehicles available. They are tangible, offer a hedge against inflation, and are a great way to diversify your investment portfolio. In fact, many investors can earn lucrative returns from investing in real estate, especially if they invest in the right location for their chosen investment strategy.

Table of Contents

1. What Is NOI?
2. What Is Cap Rate?
3. The Most Efficient Way to Calculate NOI and Cap Rate

While one can earn gainful profits from real estate, not all investment properties offer the same level of profitability. The location of the investment property, as well as the investment strategy used, can significantly affect your success. To be successful, you also need to study the income potential of a real estate investment first before you decide to buy any investment property. 

Various metrics can help you assess an investment property’s profitability, and two such metrics are the net operating income (NOI) and the capitalization (cap) rate. NOI refers to the difference between the property’s income and expenses. On the other hand, cap rate refers to the rate of return based on the NOI and the property’s value or sales price. 

Knowing the NOI/cap rate of a real estate property can help you determine whether it will make a good investment or not. While it may sound simple, calculating the NOI and cap rate should involve thorough real estate data research so you can generate accurate results. In this article, we will learn more about NOI/cap rate and discuss efficient ways to calculate them.

What Is NOI?

NOI, short for net operating income, is one of the important metrics that can help you determine whether a real estate investment will be profitable or not. NOI refers to the net income from all revenues generated from the investment property less all necessary operating expenses.

Many people wonder what does NOI stand for in business, especially in real estate. In general, NOI helps you determine the cash flow of an investment property. It shows whether your business generates more inflows (from all sources of revenues) than outflows (from the business’s operating expenses).

To calculate the NOI accurately, you need to first consider all income sources related to your real estate investment. Remember that aside from rental income, your real estate investment will also generate revenue from other sources, including:

• Parking fees
• Cleaning fees
• Fees for other services
• Extra charges for amenities 
• Sales from vending machines 
• Laundry facilities

After you determine the revenues an investment property makes, the next thing that you must do is to identify all reasonable operating expenses related to the real estate investment. The expenses include the cost of running and operating the real estate business, such as:

• Utilities
• Property taxes
• Repair and maintenance costs
• Insurance premiums
• Accounting and legal fees
• Property management fees
• Janitorial fees
• Marketing expenses

Gross Operating Income

To get an accurate NOI calculation, you need to determine the gross operating income of an investment property first. The formula for calculating the gross operating income is as follows:

Gross Operating Income = Potential Rental Income – Vacancy Losses

Keep in mind that if you invest in a rental property, you need to take into account the possible fluctuations in your rental income. There are times when your property is vacant, which means it will not generate income. Taking the vacancy rate into consideration is crucial to get an accurate NOI figure. 

Potential Rental Income

The potential rental income from an investment property refers to how much a property makes if you achieve a 100% occupancy rate. For instance, if you report a monthly rental income of $2,500, then in a year, it can generate a potential rental income of $30,000. It is the best-case scenario for the investment.

Vacancy Rates

While it is ideal to get your investment property rented out 100% of the time, it is not always the case. That’s why it’s crucial to factor in the vacancy rates when calculating your gross operating income. However, finding the vacancy rates of an investment property can be difficult. You need to conduct rental comps analysis to find the vacancy percentage you should use.

Based on our example above, let’s say the lease agreement is just for 10 months, and you don’t get to rent out the property for two months. So, your annual gross operating income is $30,000 minus $5,000 (which is two months’ worth of missed rent due to vacancy) or equivalent to $25,000. 

Related: Rental Comps: What Are They and Where Can I Find Them?

What Expenses Are Not Included in the NOI Calculation?

Certain expenses related to your real estate investment should not be included in the NOI calculation. In general, NOI should not include expenses that can be written off, as well as taxes and large one-time costs, like capital expenditures. We exclude such expenses in the NOI calculation because they do not support the true cash flow of the investment property. 

The true cash flow of a real estate investment should be able to provide insights into how profitable a property is and how much it costs to operate and maintain the investment. The NOI should be able to show you the overall health of your real estate investment based on its cash inflows and outflows. 

To provide the true cash flow of an investment property, the NOI calculation does not include the following expenses:

Income Taxes

We consider the net operating income a pre-tax calculation, which means that we do not take into consideration taxes in the calculation. 

Depreciation

Depreciation is an accounting concept, not an actual expense. Since there is no actual cash or money flowing out of the business when you write off the value of something, it is excluded from the NOI calculation. 

Mortgage Amortization

We do not take mortgage payments into account when calculating NOI because debts are not included in the calculation. Since mortgage payments can vary from one investor to another, it will significantly impact the NOI results if included. 

The purpose of calculating NOI is to determine the overall health of the investment, regardless of whether you will acquire the property through a loan or not. It is why debt service is excluded from the NOI expenses. By excluding it, we can compare investment properties based on their cash inflows and outflows alone.

Capital Expenditures

We also exclude large one-time expenses, such as renovation costs and costs of equipment, when calculating NOI.  It is because, in most cases, capital expenditures are not paid using the income generated from the investment. 

Usually, business owners finance their capital expenditures either through cash reserves or other forms of financing. Since capital expenditures do not directly affect the cash flow of the business, the NOI formula omits them. 

The NOI Formula

The formula for calculating NOI is pretty straightforward and you can use this to manually compute an income property’s NOI:

NOI = (Gross Operating Income + Other Income) – Operating Expenses

We’ve discussed how to calculate the gross operating income and which operating expenses are included in the NOI calculation. As mentioned, aside from the income that a property generates from rent, you also need to consider the property’s other income streams as long as it provides cash inflows to your business. 

An investment property can earn income outside of monthly rent payments from tenants, such as parking fees, laundry services, pet fees, and sales from laundry machines. Whatever money the property makes on top of rent should be taken into account when calculating the NOI.

NOI Sample Calculation

Let’s say you’re evaluating a duplex rental property that generates a rental income of $2,000 per month per unit. Your potential rental income per year for both units is $48,000. The property also generates a total of $1,500 per year in additional income outside of rent. The total annual operating expenses for the property is $37,000.

Given the above figures, the NOI of the property is as follows:

NOI = ($48,000 + $1,500) – $37,000

NOI = $12,500

If, for instance, the operating expenses are higher than the sum of gross operating income and other income, it will result in a negative NOI, which is essentially a net operating loss (NOL).

Related: NOI vs Cash Flow in Real Estate Investment Analysis

What Is Cap Rate?

The cap rate, short for capitalization rate, is another rate of measure that determines the profitability of an investment property. It is calculated based on the property’s NOI and sales price and is typically expressed as a percentage. Calculating the cap rate of a property helps prospective investors decide whether or not it is worth investing in. 

In general, cap rates are useful for comparing multiple investment properties to help you decide which one will make the most profits. It can help you estimate your potential return on investment. However, it’s worth noting that using the metric alone to evaluate the profitability of an investment property is not recommended. 

Using cap rates as the sole indicator for finding a property’s income potential may not be efficient as it does not take into account the financing method used for acquiring the property. Plus, it does not consider the future improved value of the property should you perform certain renovations.

The Cap Rate Formula

You can easily calculate the cap rate of a certain investment property using a cap rate calculator. You can also do it manually using the simple formula below:

Cap Rate = Net Operating Income / Property’s Sales Price or Market Value

Using the above formula, you can estimate how much a property can make over a one-year period. The cap rate metric is best used if you purchase the property in cash, as it does not take into account the method of financing you use. 

The first factor needed for calculating the cap rate is the property’s net operating income, and we’ve already discussed what it is and how to calculate the NOI. After you determine the NOI of a property, you can use that figure to find out its cap rate. 

The second factor used for calculating the cap rate is the property’s selling price or current market value. You can use the present-day value of the property based on the current market rates, or you can also use its listing price.

Cap Rate Sample Calculation

For example, you’re evaluating a rental property that’s listed at $512,000 and generates an annual net operating income of $12,500. Using the cap rate formula above, the cap rate for this particular property is as follows:

Cap Rate = $12,500 / $512,000

Cap Rate = 2.44%

Based on our example, the cap rate of the rental property is 2.44%. The next question is, is it worth investing in?

What Is Considered a Good Cap Rate?

Based on the formula, the cap rate will generate a higher value if the subject property shows a higher net operating income and a lower valuation or listing price. In contrast, it will generate a lower value if the property’s NOI is low and the valuation or selling price is high. But the question is, what is really a good cap rate?

Keep in mind that what makes a cap rate “good” depends on various factors, and the ranges for a good cap rate are not set in stone. Most real estate professionals believe that a cap rate between 8% to 12% is considered good; however, the said range does not apply to all properties. In some cases, investors find cap rates of at least 2% acceptable. 

How Do Cap Rates Determine Risks?

Aside from helping you find the best investment property to buy, cap rates are also used to determine how high a property’s investment risk is. Sometimes, properties with higher cap rates involve higher risks. In this case, high doesn’t always equal “good.” 

Generally, how good or bad a cap rate is will largely depend on the real estate market where you invest in. For example, we look at two similar properties located in different geographical areas. One is located in a big city, while the other one is in a remote location. 

The first property located in a large city will likely generate a higher income compared to the one in a remote area. However, the property in a city will likely incur high expenses and maintenance costs as well. So, you can expect properties in big cities to come with lower cap rates. 

But it does not mean that the property will not make a good investment. In fact, the lower cap rate value indicates that the property shows a better valuation and may appreciate in value more quickly. Therefore, it comes with a lower risk. 

On the other hand, the property located in a remote area with a higher cap rate may indicate that the property’s value may not appreciate as quickly. Depending on where the property is located, a high cap rate is usually also associated with higher risks.

The Most Efficient Way to Calculate NOI and Cap Rate

After learning what NOI and cap rate are, let’s find out what is the most efficient way to calculate both return metrics. 

Based on the formula for NOI/cap rate, you can easily compute the value of both metrics if you obtain all the needed information for your real estate analysis. So, the challenge here is not really about calculating the figures but more about finding the data that you need. 

Note that it takes thorough research to get accurate values for rental income, vacancy rates, other income, and operating expenses. Doing this process manually is time-consuming and generally prone to error. Fortunately, the rise of advanced technology allows real estate investors to conduct proper rental analysis without doing any manual research.

Related: 5 Steps to Conducting an Accurate Rental Market Analysis

Real estate platforms like Mashvisor provide all the necessary tools that investors need to help them make the right investment decision. Mashvisor is the most reliable real estate analytics platform when it comes to providing up-to-date and realistic computations to help investors determine a property’s profitability.

Here are the Mashvisor tools that you can use to find whether or not an investment property will be worth your time and money:

Market Finder

Mashvisor’s Market Finder allows you to easily determine the best real estate markets for your chosen investment strategy. For example, if you’re planning to buy an Airbnb for sale, you can search for the best short term rental markets through the Market Finder. You can set your custom filters based on cap rate, home value, property type, income, or occupancy rate. 

You can also choose the state where you plan to invest in, and you’ll see the top markets based on either Mashmeter score, rental revenue, cap rate, or crime rate. The Mashmeter score is an evaluation scoring system provided by Mashvisor’s machine-learning algorithm and AI technology to determine the market’s investment potential. 

Property Finder

Let’s say you’ve determined the best rental market to invest in with the help of the Market Finder. You can then take advantage of Mashvisor’s Property Finder tool to see the listings for sale in your chosen market. You just need to enter the city or neighborhood of your choice and set filters such as budget, rental strategy, and property type. 

You’ll then be provided with a list of results of properties for sale based on the criteria that you set. It allows you to easily find the right investment property that matches your criteria. The Property Finder tool is what sets Mashvisor apart from most other real estate platforms available online. Most other platforms do not allow users to search for properties for sale.

Investment Property Calculator

Once you find a property that you like, the next tool that can help you determine whether that property will make a good investment or not is Mashvisor’s investment property calculator. The tool is what’s going to help you find the NOI/cap rate and other rates of measures to determine the property’s return potential. 

Aside from NOI/cap rate, you’ll also see the cash on cash return of the property. The CoC return metric determines the profitability of an investment property based on the NOI and initial cash invested. Unlike the cap rate, the cash on cash return takes into account the method of financing used for acquiring the property. 

Using Mashvisor’s real estate investor calculator, you’ll easily get the figures for NOI/cap rate without doing your own research. Plus, you can rest assured that the real estate data provided is accurate and updated. What’s more, the calculator is interactive, so you can adjust certain figures like expenses, occupancy rate, nightly rate, and mortgage information. 

If you’re ready to find the best investment property, sign up for a 7-day free trial with Mashvisor today. 

Use NOI/Cap Rate to Find the Right Investment Property

Calculating the NOI/cap rate of an investment property is crucial for evaluating the property’s income-earning potential. The two metrics can help you make the right investment decision so you can easily avoid high-risk investments. It’s important to note, however, that NOI and cap rate should not be the only metrics to consider when finding the right investment. 

While calculating the NOI/cap rate can be done manually, it would take a lot of time on your part to do research. Plus, it can be prone to error, too. That is why it’s best to use a reliable online rental calculator to get the accurate real estate data that you need. When it comes to the best investment property calculator available, nothing can beat Mashvisor.

Mashvisor’s calculator will not only provide computation for NOI/cap rate but also for other metrics, such as cash flow, occupancy rate, and cash on cash return. In addition, you will see a side-by-side computation for both short term and long term rental strategies. The comparison makes it easier for you to determine the best strategy for your chosen property. 

Learn how Mashvisor works. Schedule a demo today to see how the platform can do wonders for your real estate venture.