How do you calculate NOI and Cap Rate? *Fun Exercise*

Question

I been seeing a lot of articles/YT Vids with different ways they calculate their net operating income and capitalization rate. I will give a screenshot with numbers below and see how your conclusion varies.

Two questions:1. What is your NOI? How did you calculate it?2. What's is your Cap Rate? How did you calculate it?

Purchasing Price of $280,000

Jeff Copeland · Answer

Debt service is not an operating expense, so those should not be used at all when calculating cap rate.

$2600 x 12 = $31,200 Potential Gross Income

Less Vacancy/Collection Losses of 5% = $29,640 Effective Gross Income

$1250/mo = $15000/yr in Operating Expenses

$29640 EGI -$15,000 OE = $14,640 Net Operating Income

$14640 NOI divided by $280k purchase price = 5.22% Cap Rate

Put another way, if you invest $280k in this property, you will see a 5.22% annual return. $280k x 5.22% = $14616

(the other $24 is just a rounding error from not carrying out the decimals)

There is literally no other correct way to calculate cap rate.

https://www.biggerpockets.com/...

Allan C. · Answer

@Yaniv Tivon once you capitalize an asset you will depreciate it, so it becomes an actual expense line item from a tax perspective. If you think about it from a cash flow perspective, pro-rating your capital expenditure on an annual basis gives you a gauge on ratable cash flow.

Jeff Copeland · Answer

Taxes and insurance are operating expenses and are included as such in the calculations above (even though these may be paid via mortgage escrows in some cases).

Debt service (principal & interest) of $1135 is not an operating expense. It's still important when calculating cash flow. It's just not part of the cap rate formula.

Mortgage insurance is generally considered to be a component of debt service, and not an operating expense.

A great wat to compartmentalize this is to think of it in terms of "Is this expense needed to operate the property?'"

Generally speaking, you cannot operate a rental property without paying for utilities, landscaping, repairs, advertising, management, property taxes, property insurance, etc. These are operating expenses.

But you can certainly operate a property without a mortgage! Pledging the property as collateral for a loan does not affect its performance (income, expenses, cap rate) in any way.

In other words, "Your mortgage interest [and PMI] may be a deductible expense, but it is not an operating expense. You may need a mortgage to afford the property, but not to operate it." This great quote is from Frank Gallinelli.

In terms of "What is the rate I should be at?" - Only a local expert can answer this question. It will vary not only from market to market, but from neighborhood to neighborhood and property class to property class. It will also change over time as the market cycle progresses.

It's usually possible to make a generalization such as "Class B quadplexes typically trade at a 6-cap in this market right now." That would be referred to as the market cap, and can be used to determine a property's value using a variation of the math above.

If you have a Class B quadplex in the same market, and it produces $50k per year in net operating income, and you know that investors are buying at a 6% cap rate right now, then you can probably assume that your property is worth $833k based on the market cap for this type of asset (because $50k ÷ .06 = $833,333).

To look at it in the other direction: If an investor paid $833,333k for it, they'd earn an annual return of 6%, because $833k x .06 = $50k.

Kaleb Dodson · Answer

If i intend to make some repairs on the property, would the capital costs then be the price I bought the home for PLUS the cost of the repairs? I keep seeing calculators just use the purchase price.

Yaniv Tivon · Answer

Hi everyone. Great reply @Jeff Copeland. I'm a bit confused about capital expenses though. Would you consider them as part of the operating expenses? I've seen posts that go either way.

Matt M Antonio · Answer

Yeah these all make sense to me! Still a kid in the block here trying to learn and excel. Very much appreciate the assist! Happy hunting..

Matt M Antonio · Answer

So Principal and interest, and mortgage insurance should be excluded? or technically mortgage insurance is not debt expense   But this helps a lot!! Thank you Jeff. Now my follow question is what is the rate I should be at? (I know it depends on the market but what if I live in Washington State). What determines the which cap rates are the best for your market? The higher the number the better I'm assuming.

How do you calculate NOI and Cap Rate? Fun Exercise

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