Valuing property with cap rates and NOI

$768,000 x 5% = $38,400 in losses.

$768,000 - $38,400 = $729,600. This is Effective Gross Income (EGI), sometimes after adding small "other income" lines like parking, laundry, or pet fees. We will keep it simple and add $12,000 of other income.

EGI = $741,600.

Build Net Operating Income (NOI)

Net Operating Income (NOI) is EGI minus operating expenses. It is the single most important number in commercial real estate, so define it precisely.

NOI includes the costs of running the building. It excludes:

• Mortgage payments (debt service)
• Income taxes
• Depreciation
• Capital expenditures (major replacements like a new roof)

Why exclude those? Because NOI measures the property itself, not how a particular buyer financed it or how the tax code treats them. Two buyers with different loans should agree on the same NOI.

Typical operating expenses

For our building, annual operating expenses might look like this:

| Expense | Annual |

|---|---|

| Property taxes | $95,000 |

| Insurance | $28,000 |

| Property management (roughly 4% of EGI) | $30,000 |

| Repairs and maintenance | $48,000 |

| Utilities (common areas) | $36,000 |

| Payroll (on-site staff) | $40,000 |

| Trash, landscaping, admin | $22,000 |

| Total operating expenses | $299,000 |

A quick sanity check: the operating expense ratio here is $299,000 / $741,600, or about 40 percent. For apartments, ratios of 35 to 50 percent are common. If a seller's numbers show a 20 percent ratio, be suspicious. They may be omitting real costs.

Now the math:

NOI = EGI ($741,600) - Operating Expenses ($299,000) = $442,600.

That is the building's annual income before financing. Memorize this workflow: Rent roll, minus vacancy, plus other income, minus operating expenses, equals NOI.

The cap rate: price versus income

The capitalization rate (cap rate) is the bridge between income and value. The formula is simple:

Cap Rate = NOI / Value

Rearranged three ways, it does everything you need:

• Value = NOI / Cap Rate
• NOI = Value x Cap Rate
• Cap Rate = NOI / Value

Think of the cap rate as the unleveraged annual yield: the return you would earn if you paid all cash and pocketed the NOI. A 6 percent cap rate means you are paying about $16.67 for every $1 of annual income. A 5 percent cap rate means you are paying $20 for that same dollar. Lower cap rate, higher price.

Where do cap rates come from?

You do not invent the cap rate. The market sets it through recent comparable sales. If similar apartment buildings in the same submarket recently traded at cap rates around 5.5 percent, that is your anchor.

Cap rates move with:

• Interest rates. When borrowing costs rise, cap rates tend to rise too, which pushes values down.
• Perceived risk. A stable, fully leased building in a strong market commands a lower cap rate (higher price) than a half-empty building in a declining one.
• Growth expectations. Markets where rents are expected to climb fast trade at lower cap rates.

For a sense of how these move over time, the St. Louis Fed's FRED database publishes commercial real estate price and rate series you can explore for free.

Deriving value

Apply the market cap rate to our NOI.

At a 5.5 percent market cap rate:

Value = $442,600 / 0.055 = $8,047,000 (approximately).

That is well above the $6 million asking price, which should make you look harder. Either the building is genuinely underpriced, or the seller's numbers are optimistic and your NOI is too high. In practice, a gap this large usually means something in the rent roll or expenses does not hold up. Verify before you celebrate.

Notice the sensitivity. Move the cap rate by half a point and value swings dramatically:

• At 5.0 percent: $442,600 / 0.050 = $8,852,000
• At 6.0 percent: $442,600 / 0.060 = $7,377,000

A 100 basis point move in the cap rate changed value by roughly $1.5 million on the same income. Basis point means one hundredth of a percent, so 100 basis points equals 1 percent. This is why cap rate assumptions get fought over in every deal.

Reverse-engineering the bid

So far we valued the property at market. But you are a buyer with a target return. You should turn the formula around and solve for the price you should pay.

Suppose your investment committee requires a going-in cap rate of at least 6.25 percent to accept the risk. You are effectively saying: "I will not pay more than the price that gives me a 6.25 percent yield on day one."

Maximum bid = NOI / Target Cap Rate = $442,600 / 0.0625 = $7,081,600.

That is your ceiling. Bidding above it means accepting a lower yield than your committee approved.

Underwrite your own NOI, not the seller's

Here is where discipline pays. Sellers present a pro forma: projected numbers that often assume best-case rents and understated expenses. Never bid off the seller's pro forma.

Rebuild NOI yourself:

• Use in-place rents from the actual signed leases, not "market" rents the seller hopes to achieve.
• Apply a realistic vacancy factor from local data, not an aggressive 2 percent.
• Include a replacement reserve, an annual set-aside for future capital replacements (often estimated at $250 to $350 per unit per year for apartments). Some underwriters treat this as a below-the-line item, but including it gives a more honest picture.

If adding a $300 per unit reserve trims NOI by $12,000 to $430,600, your maximum bid at 6.25 percent falls to about $6,890,000. Small assumption changes move real money.

The value-add angle

Cap rate math also reveals upside. Suppose you believe you can raise the average rent by $100 per unit after light renovations.

Extra income: 40 units x $100 x 12 months = $48,000 of new gross rent. After vacancy and a share of costs, assume roughly $42,000 flows to NOI.

At a 5.5 percent exit cap rate, that added NOI is worth $42,000 / 0.055 = about $764,000 in value created. That is the core logic of the value-add strategy: buy on today's income, force NOI higher, and capture the value the cap rate multiplies.

Key Takeaways

• NOI is the engine. Build it from the rent roll: Gross Potential Rent, minus vacancy and credit loss, plus other income, minus operating expenses. Exclude debt, taxes, depreciation, and capital expenditures.
• Cap rate is the market's price on income. Value = NOI / Cap Rate. Lower cap rate means higher price. Derive it from recent comparable sales, do not guess.
• Small cap rate moves swing value hard. A 100 basis point shift changed our building's value by roughly $1.5 million on identical income. Sensitivity-test every assumption.
• Reverse the formula to set your bid. Divide your underwritten NOI by your required cap rate to find the maximum price that hits your return.
• Underwrite your own numbers. Never bid off the seller's pro forma. Use in-place rents, realistic vacancy, and a replacement reserve.