Basics of Direct Capitalization - NOI and Cap Rate
To understand the Direct Capitalization Method (i.e. Direct Cap), we must first understand two other basic real estate concepts: Net Operating Income and Capitalization Rate (i.e. Cap Rate ).
Net Operating Income is the net income from a property, in a given period, after deducting operating expenses but before deducting capital expenditures, debt service, and taxes. The formula for Net Operating Income is:
Effective Gross Income – Operating Expenses = Net Operating Income
The Capitalization Rate is a complex real estate financial term that I’ll oversimplify for purposes of this course. Simply put, it is the ratio of net operating income to a property’s value (NOI ÷ Value = Cap Rate) and generally represents an owner’s return on investment in a given year before accounting for capital costs, amortization, depreciation, taxes, etc.
So while I’ll leave the definition of Cap Rate at that, keep in mind the Cap Rate is probably the most widely used, but least understood concept in commercial real estate and deserves further exploration beyond this course. If interested, you might check out this, this, or this. This is also where having a deeper understanding of finance is worthwhile, so as to understand the risk premium embedded in the cap rate you're applying.
Steps to Completing a Valuation Via Direct Capitalization
On its face, this method is incredibly simple (evidenced by the 15 second video to start this lecture!):
- Calculate a Pro Forma (i.e. Stabilized) Net Operating Income
- Determine the appropriate Cap Rate
- Divide the Net Operating Income by the Cap Rate to arrive at an estimated value
However, you're paid the big bucks for your ability to accurately complete steps one and two above - two steps that are more difficult then they seem.
In the following lectures, I'll walk you through the process in real-time, and offer some insights into what actually goes into those first two steps.