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Private Markets Pathway · Private Real Estate Investments

Net Operating Income and Cap Rates Explained

Updated 8 October 2026 · Fact-checked

Net operating income (NOI) is rental income less vacancy and operating expenses, before debt service, depreciation and income tax. The cap rate is NOI divided by value. In direct capitalization, you divide expected NOI by the cap rate to get value. In DCF, you discount NOI and a terminal value.

Understand Net Operating Income and Cap Rates

Net operating income is the income a property earns from operations. You start with potential gross income, which is what the property would earn if fully let at market rents. You subtract vacancy and collection losses and add other income, such as parking. This gives effective gross income. Then you subtract operating expenses to reach NOI.

Operating expenses cover property taxes, insurance, maintenance, utilities and management fees. They do not include debt interest or principal, depreciation, income tax, or capital expenditures. Leave these out because NOI measures the property, not the owner's financing or tax position. This lets you compare properties on equal terms.

The capitalization rate links income to value. Cap rate = NOI ÷ value. If a property sells for 10,000,000 and earns NOI of 600,000, the cap rate is 6%. Flip it around and value = NOI ÷ cap rate. This is direct capitalization. It works like a one-period valuation: a single year of income and a single rate. A lower cap rate means a higher value for the same NOI.

The cap rate is not a required return. It is approximately the discount rate minus the long-run growth rate of NOI. A market with strong expected growth has a lower cap rate than the discount rate. This link is what ties direct capitalization to DCF.

The DCF method projects NOI over a holding period, usually with a terminal value at the end. The terminal value is the expected sale price. You usually find it by capitalizing the NOI of the year after the final projection year at a terminal cap rate. You then discount all cash flows at the discount rate. A gross income multiplier (GIM) is a simpler tool. It is value divided by gross income, and it ignores differences in expenses.

Key rules to remember

Effective gross income (EGI)
EGI = Potential gross income − Vacancy and collection losses + Other income
Start of the NOI build-up. Use the order the question gives.
Net operating income
NOI = EGI − Operating expenses
Exclude debt service, depreciation, income tax and capital expenditures.
Cap rate
Cap rate = NOI ÷ Property value
Use the NOI definition that matches the market comparables, usually first-year NOI.
Direct capitalization value
Value = NOI ÷ Cap rate
Use forward (next year's) NOI when the cap rate is based on forward NOI.
Cap rate and growth
Cap rate ≈ Discount rate − Growth rate of NOI
Holds approximately for a constant long-run growth rate.
Gross income multiplier
GIM = Value ÷ Gross income; Value = GIM × Gross income
Ignores expense and vacancy differences, so it is cruder than a cap rate.
Terminal value
Terminal value at year N = NOI in year N+1 ÷ Terminal cap rate
Net of selling costs if the question gives them.
DCF value
Value = Σ NOIt ÷ (1 + r)^t + Terminal value ÷ (1 + r)^N
r is the discount rate, not the cap rate.

How to solve Net Operating Income and Cap Rates questions

Use this order for any NOI, cap rate, direct capitalization or DCF question. Show each line so a correct number earns full credit.

  1. 1Read the command word and what is asked: NOI, cap rate, value, terminal value or a comparison.
  2. 2Build NOI from the top: potential gross income, less vacancy, plus other income, less operating expenses.
  3. 3Remove items that do not belong in NOI: interest, principal, depreciation, income tax and capital expenditures.
  4. 4Check which year's NOI the cap rate applies to. Use year 1 or forward NOI if the cap rate is on forward NOI.
  5. 5For direct capitalization, divide NOI by the cap rate. For GIM, multiply gross income by the multiple.
  6. 6For DCF, find the terminal value by dividing the NOI after the last projection year by the terminal cap rate. Deduct selling costs if given.
  7. 7Discount each NOI and the terminal value at the discount rate, then add them up.
  8. 8Sanity check: does the implied cap rate (NOI ÷ value) look reasonable against the market rate?

Quickest way: Cap rate shortcut

When to use it: Use when the question asks for value or cap rate and gives NOI without a multi-year projection.

  1. Compute NOI first and cross out any financing or tax items.
  2. Value = NOI ÷ cap rate, or cap rate = NOI ÷ value.
  3. For a change in cap rate, remember value moves in the opposite direction.
  4. For a DCF with growth, use cap rate ≈ r − g as a check on your terminal value.
  5. Write the number on its own line in the answer box.

Common mistakes in Net Operating Income and Cap Rates

  • Deducting interest, depreciation or income tax when computing NOI.

    Candidates mix up NOI with net income from an accounting statement.

    Fix: NOI is before financing, depreciation and taxes. Deduct only operating expenses.

  • Using the discount rate as the cap rate.

    Both are percentages applied to a property, so they look interchangeable.

    Fix: Cap rate ≈ discount rate − growth. They are equal only when NOI growth is zero.

  • Using the wrong year's NOI in the terminal value.

    Candidates capitalize the final projection year's NOI.

    Fix: Capitalize the NOI of year N+1 to get the value at the end of year N, unless the question says otherwise.

  • Forgetting to deduct vacancy before operating expenses, or deducting vacancy twice.

    Several loss items appear in the question and the order is unclear.

    Fix: Work down the build-up line by line. If the income given is already net of vacancy, do not deduct it again.

  • Treating GIM as if it accounts for expenses.

    It looks like a cap rate shortcut.

    Fix: GIM uses gross income only. It is less reliable when expense ratios differ between properties.

  • Forgetting selling costs in the terminal value.

    The cost is given late in the vignette.

    Fix: Subtract selling costs from the terminal value before discounting if the question states them.

Worked examples

Example 1

An office building has potential gross income of 2,000,000, vacancy and collection losses of 5% of potential gross income, and other income of 50,000. Operating expenses are 700,000. Interest on the mortgage is 300,000 and depreciation is 150,000. Comparable properties sell at a cap rate of 7%. Estimate the value by direct capitalization.

Show the solution
  1. Vacancy loss = 5% × 2,000,000 = 100,000.
  2. EGI = 2,000,000 − 100,000 + 50,000 = 1,950,000.
  3. NOI = 1,950,000 − 700,000 = 1,250,000. Interest and depreciation are excluded.
  4. Value = 1,250,000 ÷ 0.07 = 17,857,143 (rounded).

Answer: NOI is 1,250,000 and the estimated value is about 17,857,143.

Example 2

A retail property is expected to produce NOI of 800,000 in year 1, growing 3% a year. An investor will hold it for 3 years and sell at the end of year 3 using a terminal cap rate of 8% applied to year 4 NOI. Selling costs are 2% of the sale price. The discount rate is 9%. Estimate the value today.

Show the solution
  1. NOI year 1 = 800,000.
  2. NOI year 2 = 800,000 × 1.03 = 824,000.
  3. NOI year 3 = 824,000 × 1.03 = 848,720.
  4. NOI year 4 = 848,720 × 1.03 = 874,181.6.
  5. Sale price at year 3 = 874,181.6 ÷ 0.08 = 10,927,270.
  6. Net sale proceeds = 10,927,270 × 0.98 = 10,708,725.
  7. PV of NOI: 800,000 ÷ 1.09 = 733,945; 824,000 ÷ 1.1881 = 693,543; 848,720 ÷ 1.295029 = 655,372. Sum = 2,082,860.
  8. PV of net sale proceeds = 10,708,725 ÷ 1.295029 = 8,269,090.
  9. Value today = 2,082,860 + 8,269,090 = 10,351,950 (approximately).

Answer: The estimated value today is about 10,351,950.

Exam tips

  • Write the NOI build-up line by line. Method marks and the final number are easier to earn when each line is visible.
  • Watch for distractor items such as interest, depreciation and tax. They are included to test whether you know NOI's scope.
  • In terminal value questions, check which year's NOI the cap rate is applied to and whether selling costs are given.
  • When asked why value changed, link cap rate movement to value: lower cap rate means higher value for the same NOI.
  • Item set questions often ask for a comparison between direct capitalization and DCF. DCF handles uneven cash flows and changing growth. Direct capitalization is simpler and relies on good comparables.

Net Operating Income and Cap Rates: frequently asked questions

How do you calculate net operating income in real estate?

Start with potential gross income, subtract vacancy and collection losses, and add other income to get effective gross income. Then subtract operating expenses. Do not deduct debt service, depreciation, income tax or capital expenditures.

What is the cap rate formula for CFA Level III?

Cap rate = NOI ÷ property value. You can rearrange it to value = NOI ÷ cap rate. Use the NOI that matches the basis of the cap rate, which is often first-year or forward NOI.

What is the difference between a cap rate and a discount rate?

The discount rate is the required return on the property. The cap rate is approximately the discount rate minus the long-run growth rate of NOI. With no growth they are equal.

What is the gross income multiplier and when is it used?

GIM is property value divided by gross income. You multiply a comparable GIM by the subject property's gross income to estimate value. It is a quick check, but it ignores expense differences, so a cap rate is usually more reliable.