Capitalization Rate

The capitalization rate is net operating income divided by purchase price or market value. It is the main use of an NOI figure: divide NOI by the cap rate comparable properties trade at and you have what the property is worth. Financing never enters the calculation, which keeps it comparable across buyers.

The default house produces $28,892 of NOI on a $500,000 price, a 5.78% cap rate. Turn the formula around and the same NOI is worth $444,492 at a 6.5% market cap rate, so the house is priced about $55,500 above what a 6.5% buyer would pay. Every $1,000 of NOI is worth $15,385 at that rate.

Because the cap rate is a ratio, a small NOI error becomes a large value error. Leaving a $100 a month expense out of the statement adds $1,200 of NOI and about $18,500 of apparent value. The Wikipedia article on capitalization rate works through the same arithmetic and separates cap rate from cash flow, which comes after the loan.