In real estate, the term ‘cap rate’ is often confused to be the same as cash on cash returns, and ‘NOI’ to be the same as ROI. Every current or intending real estate investor should know what these terms mean, and how they differ from each other. So, what is NOI and cap rate?
What Is NOI and Cap Rate?
NOI, known as Net Operating Income, is the annual return on investment that a property generates, minus all operational costs such as property management fees and taxes. On the other hand, capitalization rate, usually called Cap Rate, refers to the measurement of a property’s potential rate of return, based on its NOI and current value.
Knowing the cap rate of an investment property is important because it helps you decide whether it is a potentially profitable investment. Ideally, a property with a high cap rate signifies a potentially higher return, and so you could decide to invest in it. Cap rate also gives you an idea of how quickly you can recoup your initial investment.
How to Calculate NOI
Before moving on to the formula, it is important to note that NOI is different from Net Yield. Net yield is usually calculated in percentage and refers to the rate of return on investment after deducting operational costs from annual income, and then dividing that figure by the property value.
Calculating the NOI, however, is a very simple process. It involves only deducting the property’s operational expenses from the annual income it generates. For instance, let’s say you purchase a commercial property for a price of $800,000, spend $15,000 in operational costs, and get a total of $150,000 in annual income.
To calculate the NOI, you simply deduct $15,000 from $150,000 ($150,000 -$15,000). That gives you $135,000 as your net operating income. Examples of operational costs on a property include:
- Closing costs during purchase of property
- Building insurance
- Mortgage repayment and interest fees
- Maintenance costs such as inspections of electrical and plumbing systems, and general repairs.
- Property taxes
How to Calculate Cap Rate
To calculate the cap rate of a property, you divide the NOI by the property’s current value. Using the example above, if the property was purchased at $800,000, and the NOI is $135,000, the cap rate is around 5.9%, approximately 6%. This was obtained by dividing $800,000 by $135,000 ($180,000/$135,000).
What Is a Good Cap Rate?
The definition of a good cap rate differs from investor to investor. What might be a good cap rate for one, might be a bad one for another. Ultimately, it boils down to the level of risk you are willing and able to take on an investment.
This is because a higher cap rate poses a higher level of risk. If you are not looking to take too much risk on an investment, then you should go for a property with a low cap rate.
One other thing that determines whether the cap rate of a property is good is what you intend to do with the property. If you are buying a property, you might want to go for one with a high cap rate. If you are selling, however, it’s better to sell one with a lower cap rate.
Factors That Affect NOI and Cap Rate
In addition to normal trends of the market, NOI and cap rate of a real estate property are affected by other factors. Topping the list is the property location, as well as how effectively you are maximizing income from your property.
The location of a property plays a huge role in its net operating and cap rate. This is mainly because operational costs differ from state to state. For example, Ohio has an average property tax rate of 1.78, with Cincinnati having 1.81.
This means that the NOI of properties in Cincinnati would be higher than that of other cities in the state with higher property taxes.
Make Use of the Right Realtors
Every commercial real estate property needs the right amount of publicity to potential tenants to maximize its annual income. To get this, you should work with a real estate company that would put your property right in the face of tenants.
If you are in search of a good realtor, Si Vales Valeo Real Estate might be just the right choice for you.
How Is Cap Rate Different From Cash on Cash Return?
The difference is that with cap rate, the financing method used to purchase a property is not considered while analyzing its potential rate of return, while with cash on cash return, the financing method used for property purchase is taken into consideration while measuring the rate of return.
Note that the cap rate of a property is not the only thing to consider when looking to invest. While it shows the potential return rate of a property, it does not offer an accurate prediction. It is advisable to consult with your Si Vales Valeo Real Estate agent before going ahead to purchase your commercial property.