What is the Cap Rate and NOI on Rental Properties and are they Important?

Found this great blog on Linked by Mark Ferguson posted on March 4, 2014. If you are looking for a Boise investment property such as a fourplex, duplex or commercial investments, please visit us at www.ironeaglere.com.

If you have been around Boise investment properties you have probably heard the term cap rate and NOI.  The cap rate on an investment property is a measure of what the returns will be assuming you pay cash for a property.  I don’t use cap rate on my investment properties, because it doesn’t factor financing costs.  I prefer to use the cash on cash return on my properties, but the cap rate can still give you a basic idea of a property’s returns.

NOI is the net operating income on a rental property and does not factor in debt service.  The NOI can be another indicator of rental property returns, but can also be easily manipulated.

How do you figure the cap rate on a property?

The cap rate is a very simple formula; net operating  income divided by the price of a property.  For example if you buy a home for $100,000 and the net income is $10,000 a year, the cap rate is 10%.  ($10,000/$100,000=10%)

What is the net operating income? (NOI)

The net operating income is how much money a rental property produces after expenses.  This is another simple calculation and can be figured using our cash flow calculator.  The NOI does not include debt service, which our calculator includes, but you can enter the mortgage payments as zero to determine the NOI.  For example if the rents are $10,000 a year on a rental property and the yearly expenses are $3,000, then the NOI is $7,000.

What expenses are included in the NOI?

You will find different investors include different expenses to determine the NOI.  Some investors may include vacancies and property management and others may not.  Some investors may not even include any maintenance in their NOI projections to make their properties appear more profitable.  If you are basing a purchase decision on the cap rate then you need to make sure all the expenses are accounted for.  If the total rent for a property is $10,000 a year and the NOI is $10,000, then there are obviously expenses being left out of the equation.

How can the cap rate vary greatly on the same property?

The NOI greatly affects the cap rate.  If the NOI does not include all expenses on a property, then the cap rate is going to be artificially inflated.  I don’t like using the cap rate as an indicator of returns, because it does not factor into account debt service and the cap rate can be easily manipulated.

Why Cash flow is more important than the NOI

I think the  cash flow on a rental property is much more important than the cap rate.  The cash flow tells you exactly how much money you are going to make including expenses and debt service.  Our cash flow calculator even helps you determine what the maintenance and vacancies may be on a property per month.

Why the cash on cash return is better than the cap rate

The cash on cash return tells you what returns you are getting on your cash invested into a property.  The cash on cash return takes into account the amount of money invested based on leverage.  The cap rate completely ignores leverage, which will make a huge difference in the actual returns an investor sees.  Our cash on cash calculator can help you calculate the actual returns on a rental property including the debt service.

What can the cap rate tell you about different markets?

The cap rate gives a very basic idea of the return rate on rental properties.  If you are looking to invest in long-distance properties, the cap rate can give you an idea of the returns in that area.  Average cap rates in the country can range from 5% to 15%.  There are many other factors to consider when determine where to buy, but cap rate can give you an idea on returns.

How can cap rates help you decide on single family versus multifamily

The cap rates can also give you an idea of the different returns on single family homes versus multifamily homes in an area.  In Colorado the cap rate for a multifamily property tends to be around 5%.  For a single family home you can see cap rates at around 8% in my area.  I buy my properties below market value and see cap rates at 10% or higher on the purchase of my single family rentals.  In other markets those percentages may be reversed on single family and multifamily homes.

Conclusion

The cap rate and NOI can be used to help determine the returns on rental properties, but there are also many other factors to consider like the cash flow and cash on cash returns.  I personally do not pay attention to cap rate or NOI, because it does not giving me a clear picture of my returns.

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