NOI and Cap Rates: The Ugly Truth

Two of the most common metrics used to measure the profitability of a multifamily real estate investment are net operating income (NOI) and capitalization rate (cap rate). These metrics can also be used to provide a quick comparison between different properties in order to help investors make informed decisions about which investment might be the best deal.

What some beginner investors don’t realize is that NOI and cap rate calculations are not always the most accurate tools for predicting a property’s profitability. The KataLYST Team has spent countless hours exploring commercial real estate trends and common practices, including deep dives into calculations such as NOI and cap rate. Read on to find out more about how to calculate cap rate from NOI accurately and which metrics might be more accurate for determining profitability in multifamily markets.

What does NOI mean in multifamily?

NOI stands for net operating income. NOI is a before-tax figure similar to the EBIT (earnings before interest and taxes) figure commonly used among other industries. Net operating income includes all revenue from the property, minus all reasonably necessary operating expenses.

The “reasonably necessary” qualification is the grey area in this calculation. Later, we’ll explore some of the variations that can occur as people approach NOI calculations differently.

What does cap rate mean in multifamily?

Cap rate, or capitalization rate, is a calculation used to assess a property’s profitability and return potential. The equation for cap rate actually uses a property’s NOI and its current market value to predict an average rate of return.

Because cap rates use NOI to calculate ROI (now there’s a mouthful), they can be unreliable if the NOI is not calculated accurately.

How to calculate cap rate from NOI

The formula for calculating capitalization rate for a property is simply net operating income/current market value. The resulting percentage represents an estimated annual return on investment.

Cap rates can be a useful tool for estimating a property’s profitability and generates a quick, at-a-glance comparison metric for multiple properties. But there are risks involved when looking at NOI and cap rates.

Top 3 Reasons Cap Rate and NOI Can Be Deceptive

1. Not Every Owner or Agent Calculates NOI the Same Way

One of the top reasons cap rate and NOI can be deceptive metrics is due to the simple fact that different owners and agents may calculate NOI differently. Typically, NOI involves total revenue minus total operating expenses. Revenue should include things like:

  • – Rental income
  • – Parking fees
  • – Laundry machines
  • – Other service fees

Operating expenses should include things like:

  • – Insurance costs
  • – Utilities
  • – Property management fees
  • – Property taxes
  • – Repair and maintenance costs

Issues arise when there are discrepancies in what one owner or agent includes in the NOI compared to another owner or agent. Some of the above expenses may be excluded from the NOI calculation. Miscellaneous expenses like cleaning costs and vacancy costs are often forgotten. It’s not always clear which items are included in the NOI calculation, which makes comparing different NOI and cap rate numbers difficult.

2. NOI Can Be Deliberately Manipulated

While some variation in NOI calculation is natural, some owners and agents deliberately manipulate the NOI numbers to put the property in a more favorable light for potential buyers which is often called a “Pro-Forma” and attempts to show what a property is capable of doing; however, these “Pro-Forma” numbers should be heavily investigated to determine their accuracy.

3. Inaccurate NOI Can Impact Cap Rate

Because NOI is used to calculate cap rates, both numbers can be rendered useless if NOI is inaccurately calculated. If you’re suspicious about what has been included or excluded from a property’s NOI, it’s likely the true cap rate is different from what’s being advertised.

Another (Better) Way to Measure the Value of a Multifamily Property: Price Per Unit

At the KataLYST Team, we don’t recommend looking solely at NOI and cap rate to determine whether a multifamily real estate investment is likely to be profitable. Instead, we suggest looking closely at numbers like the price per unit and price per square foot. Unlike NOI and cap rate, price per unit and price per square foot are much less likely to be manipulated.

As a buyer, you can find out exactly how many units are in a building and what the property’s square footage is. These numbers are fixed for each property and can be easily compared across different listings.

If you do look at NOI for a potential commercial real estate investment, understand what went into that NOI calculation. And if you’re comparing cap rates, investigate that NOI figure. As we discussed previously, owners and agents will calculate cap rate from NOI, and if the NOI does not include the expected expenses, it won’t be accurate.

Learn More About Commercial Real Estate Trends in Iowa

With years of experience in multifamily investing and commercial real estate trends, the KataLYST Team is eager to partner with you and help you on your property investment journey. Reach out today to learn more, or explore our current listings.