im in the process of buying a residential income property and am having a tough time figuring out what CAP rate and NOI is. i google it and read and read, but it seems greek to me. i just dont understand it. am i reading too hard? what exactly is it and how does it effect the property? thanks in advance.

-Tony N.

CAP rate = Capitalization Rate. Basically, if you paid all cash for a property it is the return you would receive on your money based on the income the property produces. So, if you pay $1MM for the property and it throws off $100k a year, it would have a CAP Rate of 10%...or it would be a "10 CAP" if you are in the know.

NOI = Net Operating Income. This is the income after you have deducted vacancy losses and normal operating expenses (but, not debt service aka: loan payments). Usually, you can figure what vacancy is running for a particular property type (B apartments, office space, retail, etc) in a particular area. You take that factor (say 2%) and subtract it from the total income the property produces. Then you will subtract out your normal expenses (ie: utilities, management, repairs, advertising, etc). What you have left is your NOI. This is before your debt service or loan payments.

CAP rates are not a good way to evaluate a piece of income property as they can be misleading. Many times they are based on what we would call Pro-Forma (or expected) numbers rather than actual numbers. There are really many things that can make this a bad indicator of an investment's likely performance. But, CAP rates are a good way to quickly qualify a property along with a few other numbers.

NOI is just another piece of the puzzle as well. Neither affect the property one way or another. They are just terms brokers and investors use to describe how a property performs.

if CAP rate is not a good way to evaluate property, how come it is used so often?

Because it is an easy number to calculate.

To figure out if the property is going to make you money you need to factor in a lot of stuff. Included you need to know about the tax savings, what you lost potential income is on your down payment, apprecation rate, depreciation, vac factor, repair factor, and so on.

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Exactly and it is also an easy number to manipulate. So, a broker or property owner might throw around a number like 8.5% CAP. That number might be based on Pro Forma numbers and might not be what the property is actually operating at. They might say, well, the rents are low but you can get $xxxx no problem. It is something that can be used to compare apples to apples, but you have to get in there and figure the numbers for yourself before you can use it. Make sense?

i got it now! damn you guys are great...

so if im buying a prop for $500,000 and the cap rate is 10%, im looking to make roughly about $50,000 net income right?

i mean $50,000 "NOI" right? =)

Not exactly. If you were to pay cash for the property, $500k in this case, and it was a real 10% CAP, then you would expect that the property would produce 50K in income annually. That is not net of your expenses.

Using a true triple net leased property, you could expect that the 50K would be net to you. That is probably the only time CAP rates are a good way to compare properties.