Calculating Property Value based on NOI (Net Operating Income)

[Rick L.]

I'm formulating a spreadsheet to assist me in quickly analyzing potential rental properties. I would like to calculate the property value based on NOI using the following formula:

• Property Value = Net Operating Income/ Capitalization Rate

I'm confused as to why a higher Cap Rate would decrease the property value.  Wouldn't a higher Cap Rate make the property more desirable?  In this case it decreases the value.  What am I missing here?

[Steve L.]

I am a little confused about your question.  

Making the assumption that your goal of this spreadsheet is to decide if this property is a good investment or not?  

If this is the case, you would take your calculated or pro forma net operating income and divide it by your desired leveraged rate of return (cap rate).

Let's say, Property A, you determine will generate 100,000 net operating income (NOI) per year. You want to make 12% on your money and pay cash. You would be willing to pay 100,000 / .12 = 833,333.34.

Now let's say, an appraiser tells you  Class A apartments usually sell at an 8 cap rate.  Property A is a Class A apartment.  You would assume Property A would appraise around 100,000 / .08 = 1,250,000.  

Now let's say, Property A is listed for 1,500,000 and you want to determine what cap rate the Seller is expecting to get. You take 1,500,000 listing price / 100,000 NOI = 6.67. This means the Seller is marketing it at a 6.67 cap rate.

Now to answer your question:

Wouldn't a higher Cap Rate make the property more desirable?

The Seller's goal is to find a willing Buyer to pay as much as possible.  The Buyer's goal is to find a willing Seller who will take as little as possible.  Properties are usually broken into asset classes and listed based on what cap rate those asset classes sell for.  Class A buildings in New York City might having willing Buyer's who typically pay 4 cap rates.  Whereas; houses in the rough part of Detroit take a 20 cap rate to find a willing Buyer.  Remember this is also a function of cheap debt.  A Class A New York City building is probably pretty easy to finance at ~3% interest, whereas, the house in Detroit is a lot harder to finance.  

Make sense?