NOI and Cap Rate: How Net Operating Income Sets a Property's Value

Net operating income is what a property earns. Cap rate is what buyers will pay for each dollar of it. Put the two together and you have the income approach to value, the method appraisers and lenders use for every rental larger than a single house, and one that works just as well on a single house.

The formula

Value = net operating income / cap rate

Cap rate goes in as a decimal. A property producing $18,270 a year in a market where comparable rentals sell at a 6.5% cap rate is worth $18,270 / 0.065, or $281,077. Rearranged, the same equation gives the cap rate on any sale: $18,270 / $300,000 is 6.09%.

Financing does not appear anywhere in it. Two buyers with different loans pay the same price for the same NOI. That is the point of the measure. It prices the building, not the buyer’s balance sheet. What happens after the mortgage is covered in NOI vs cash flow.

The income approach in an appraisal

Appraisers value income property three ways: comparable sales, replacement cost and the income approach. For rentals the income approach usually carries the most weight, and it has two steps.

First the appraiser builds a stabilized NOI. Stabilized means what the property should earn in a normal year: market rent, a market vacancy allowance, management at a market fee whether or not the owner pays one, and often a reserve for replacements. Then the appraiser picks a cap rate from recent sales of similar properties and divides.

Fannie Mae’s small residential income appraisal form, Form 1025, uses a gross rent multiplier rather than a cap rate for two to four unit properties, but lenders underwriting the loan still look at NOI against debt service. Above four units, cap rate is the standard.

$18,270 of NOI at every cap rate

The default property on this site, a $300,000 house renting for $2,500 with 5% vacancy, $3,600 of taxes, $1,500 of insurance and 18% of collected income for maintenance, reserves and management, produces $18,270 of NOI. The NOI formula guide shows every line. Here is what that income is worth as the cap rate moves.

Market cap rate	Value of $18,270 NOI	Versus $300,000 price
4.0%	$456,750	+$156,750
5.0%	$365,400	+$65,400
6.0%	$304,500	+$4,500
6.5%	$281,077	($18,923)
7.0%	$261,000	($39,000)
8.0%	$228,375	($71,625)
9.0%	$203,000	($97,000)
10.0%	$182,700	($117,300)

Same house, same rent, same expenses. The value ranges from $182,700 to $456,750 depending only on what buyers in that market demand. This is why “what is a good cap rate” has no national answer, and why the cap rate calculator on the sister site asks for a target rate rather than assuming one.

Read the table the other way and it tells a seller what the market is saying. If comparable sales are at 7% and the asking price is $300,000, the buyer’s math says the NOI is $39,000 short of justifying the price.

What $1,000 of NOI is worth

Divide $1,000 by 0.065 and you get $15,385. Every additional $1,000 of annual net operating income adds $15,385 of value at a 6.5% cap rate. At 5% it adds $20,000. At 8% it adds $12,500.

That multiplier is the reason small operating changes matter so much more than they look. A $100 a month rent increase on the default property adds $935 of NOI after vacancy and percentage expenses, which is $14,385 of value. A $300 insurance saving is $4,615 of value. A property tax appeal that trims $500 is worth $7,692. How to increase NOI works through the full list.

The same multiplier cuts the other way. Underestimate expenses by $1,000 a year and you overpay by $15,385.

Going-in cap rate versus market cap rate

A going-in cap rate is the NOI you expect in year one divided by the price you are paying. It is your yield on the purchase. A market cap rate is what comparable properties have been selling for, and it is the number that sets value.

If you buy at a 7% going-in cap rate in a 6% market, you bought below value. The property is worth $304,500 on $18,270 of NOI and you paid $261,000. That gap is real equity on day one, and it usually exists because something about the property scared other buyers off: deferred maintenance, a below-market lease, a rough block.

If you buy at 5% in a 6.5% market, you paid $365,400 for something worth $281,077. Buyers do this when they expect rent growth, plan to add units or are buying a home that happens to have a rental unit attached. Each of those can be a fine reason. None of them changes the current value.

Every NOI on this site has a page showing its value at each cap rate. Start with $20,000 of NOI or $50,000.

How sellers inflate NOI

A listing pro forma is a sales document. The common moves, in order of how often they appear:

• Market rent instead of actual rent, with no note that the current tenant pays $200 less.
• Zero vacancy, because the unit has been occupied for three years.
• No management fee, because the owner manages it.
• No reserve for the roof, water heater or appliances.
• Last year’s tax bill, not the bill after the county reassesses at the sale price.
• Insurance from a policy bought before the last two rate increases.

Each one is defensible on its own. Together they can turn $18,270 of NOI into $24,000, and at 6.5% that is $88,000 of phantom value.

A buyer rebuilds the statement from the bottom. Rent from the lease and a rent comp search. Vacancy at 5 to 8%. Management at 8 to 10% of collected rent. Reserves at 5 to 10%. Taxes from the county’s own estimator at the purchase price. Insurance from a fresh quote. Then run it in the calculator and divide by the market cap rate. Whatever the pro forma said, that is the number to bid against.

What a lender’s NOI does to value

Lenders underwrite NOI more conservatively than sellers and often more conservatively than buyers. A typical small commercial lender applies a minimum vacancy of 5%, a management fee of 5% or more regardless of who manages, and a replacement reserve of $250 to $300 per unit per year. The lender’s NOI is then divided by the loan’s required debt service coverage ratio to find the maximum loan.

On the default property the lender’s NOI and the site’s NOI are close, because the site’s assumptions already include management and reserves. A pro forma NOI without them is not close. When the lender’s number comes in 15% below the seller’s, the loan shrinks by 15% and the buyer has to bring more cash or renegotiate.

This is the practical reason to build NOI the lender’s way from the start. The value that matters is the one the next buyer’s appraiser and lender will accept, and they will both add back everything the pro forma left out.

Using the relationship in both directions

Buying: build your own NOI, find the market cap rate from three or more recent sales of similar properties, divide. Bid off that value, not the list price.

Selling: the same math tells you which improvements to make before listing. An expense you can cut permanently, or income you can add and document with a lease, is worth 15 times its annual amount at a 6.5% cap rate. Cosmetic work that does not change NOI is worth whatever the comparable sales approach gives it, which for a rental is usually less.

Holding: recompute NOI and apply the current market cap rate once a year. If cap rates in your market have moved from 7% to 6%, your $18,270 of NOI went from $261,000 to $304,500 of value without a single change to the property. That is the kind of equity a refinance can pull out, which is the whole premise of the BRRRR method and the reason NOI, not rent, is the figure to track.