Clarifying Terms: The Relationship of Cap Rates, Market Values, and NOI

This post seeks to clarify terms, showing the relationship between cap rates, market values, and NOI

Our first two terms: An example

• Cap rate (capitalization rate): the expected rate of return on a property
• Market value: what the property is worth in the current market

Let’s look at the relationship between the two. A property whose market value is $500,000 and brings in $37,500 for a given year has a cap rate of 7.5%. [$37,500/$500,000 = .075 or 7.5%]

A note on cap rate: The market of investors in a given area determines the cap rate. Like interest rates, cap rates are a reflection of perceived risk. Riskier areas or riskier deals have higher cap rates; this makes sense--the return should be greater to warrant taking greater risk.

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Let’s add another term:

• NOI (net operating income): That is the “$37,5000” in the scenario above. NOI is the REVENUES (money brought in) MINUS the EXPENSES (costs) to operate  a particular asset.

• So if we could make that “$37,500” larger, we would--in turn--raise the property’s market value. To illustrate: Let’s say we found a way to raise our NOI to $42,000 with cap rate holding steady at 7.5%. This increase of NOI would raise the market value to $560,000, a $60,000 increase.

The “knobs” which we as property owners have the most control over are the revenues and expenses which determine NOI.  Actively managing and improving the financial performance, or NOI of a property, is a means to increasing the value of the investment.