Net operating incomeNOI
A property's annual income after vacancy and operating expenses but before debt payments and income taxes; the number most other real estate math starts from.
Glossary
Capitalization rateCap rate
The ratio of a property's annual net operating income to its price or value; it converts a stream of income into a lump-sum value.
A capitalization rate is the yield an investor would earn in the first year if they bought a property for cash. It is calculated by dividing the property's net operating income by its price. Turned around, it is the number that converts income into value: a building's worth is its NOI divided by the cap rate buyers are willing to accept.
Capitalization rate
Cap rate = NOI ÷ value
Value = NOI ÷ cap rateAssume NOI of $1,500,000. At a 5.0% cap rate the building is worth $30.0 million; at 6.0% it is worth $25.0 million; at 7.0% it is worth $21.4 million. Same income, three different values.
Cap rates move with interest rates, perceived risk, and expectations about rent growth. A lower cap rate means buyers are paying more for each dollar of income, usually because borrowing is cheap or the income is seen as safe. A higher cap rate means the opposite.
For housing costs, the cap rate matters because developers compare the value a finished building will command against what it costs to build. When cap rates rise, finished buildings are worth less, the gap between value and cost narrows, and projects that would have been built are shelved. The yield on cost a developer needs is usually set with the cap rate in mind, and the exit cap rate is the version of this number used to estimate a future sale price.
Where this comes up
Analysis that uses capitalization rate in the arithmetic.