Income Approach: NOI, Cap Rate, Property Value, and Cash-on-Cash Return

For a direct-capitalization study problem, value equals annual net operating income divided by the capitalization rate. Identify whether the income is already net, and put the amounts on the same time basis before calculating.

Use the rate as a decimal: 8% = 0.08. This is a simplified valuation exercise. A cap rate is not the mortgage interest rate, and applying a supplied rate does not replace a property appraisal.

Jump to: Worked example: monthly net income is already given · When gross income is given instead · Check the direction of your answer · Cash-on-cash versus cap rate

Worked example: monthly net income is already given

A practice problem states that a property has monthly net operating income of $4,500 and a capitalization rate of 9%. It separately mentions $1,200 in monthly operating expenses already deducted in arriving at that NOI.

1. Annual NOI: $4,500 × 12 = $54,000.
2. Convert the rate: 9% = 0.09.
3. Value: $54,000 ÷ 0.09 = $600,000.

Do not deduct the $1,200 again. The word “net” and the problem’s explanation tell you the expenses have already been accounted for. If a question uses “net income” without defining it, read the surrounding facts; do not assume cash flow after mortgage payments is NOI.

When gross income is given instead

Suppose annual potential rent is $120,000, combined vacancy and collection loss is 5%, no other income is given, and annual operating expenses are $34,000.

1. Vacancy and collection loss: $120,000 × 0.05 = $6,000.
2. Effective gross income: $120,000 − $6,000 = $114,000.
3. NOI: $114,000 − $34,000 = $80,000.
4. At an 8% cap rate, value is $80,000 ÷ 0.08 = $1,000,000.

Mortgage debt service is not an operating expense in this NOI calculation. Neither is the owner’s income tax or tax depreciation. See Vacancy and Collection Loss: Calculate EGI and NOI.

Check the direction of your answer

With the same NOI, a higher cap rate produces a lower indicated value. At $60,000 annual NOI, an 8% rate indicates $750,000; a 10% rate indicates $600,000. This is a mathematical relationship, not a prediction that income or market rates will stay fixed.

Cash-on-cash return versus capitalization rate

A cap rate compares property NOI with property value or price. Cash-on-cash return compares the investor’s annual cash flow with the cash invested. Changing the financing can change the cash-on-cash return even when the property’s NOI and price remain the same.

For a simple exercise with no additional cash adjustments, before-tax cash flow equals NOI minus annual debt service. Initial cash investment can include the down payment, acquisition costs, and initial improvements supplied by the question. Do not use the full price as the denominator unless the stated facts make it the cash investment, and do not replace initial cash with today’s market equity.

Worked example: the same property, two different percentages

Assume a $600,000 purchase, $48,000 annual NOI, $30,000 annual debt service, and $150,000 initial cash investment. There are no other cash outlays or adjustments in this exercise.

1. Cap rate: $48,000 ÷ $600,000 = 8%.
2. Before-tax cash flow: $48,000 − $30,000 = $18,000.
3. Cash-on-cash return: $18,000 ÷ $150,000 = 12%.

If debt service were $42,000 with all other assumptions unchanged, cash flow would be $6,000 and cash-on-cash return 4%, while the cap rate would still be 8%. Financing can help or hurt the investor’s cash return; it also introduces obligations and risk.

Cash-on-cash return does not include unrealized appreciation or treat principal reduction as spendable cash. It is not the same as a total return or an internal rate of return. The FREC Course II investment objectives include capitalization and equity dividend rates. Pair this lesson with capital gains and adjusted basis when studying investment taxes.

Quick check

Annual NOI is $36,000, annual debt service $24,000, and initial cash investment $100,000, with no other adjustments. Cash-on-cash return is 12%: ($36,000 − $24,000) ÷ $100,000. Using $36,000 in the numerator would confuse NOI with cash flow.

Try three practice questions

1. Annual NOI is $72,000 and the supplied cap rate is 8%. What is indicated value?
2. A property is valued at $800,000 and has annual NOI of $64,000. What is its cap rate?
3. Monthly NOI is $3,000 after operating expenses. At a 6% cap rate, what is indicated value?

Answers and explanations

1. $900,000. $72,000 ÷ 0.08.
2. 8%. $64,000 ÷ $800,000 = 0.08.
3. $600,000. Annual NOI is $36,000; $36,000 ÷ 0.06. Do not deduct expenses twice.

Keep studying

Review how to choose a math formula. Return to the exam-prep guide.

Submit a support request with your course, lesson or practice-question number, and the step you want explained. These are original study exercises, not recalled state-exam questions.