Before investors buy a property, they want to make sure that they’re making a good investment. That’s reasonable.

To do this, investors need to determine the approximate value of the income-producing property they’re interested in acquiring. This involves crunching some numbers to get a better understanding of a property’s **gross income** and **net operating income potential**, as well as the property’s capitalization rate. Let’s take a look at how these numbers work together to present investors with a bigger picture. For instance, investors looking to determine approximate value of their income producing properties do this by calculating:

### Net operating income ÷ capitalization rate = approx. value

It’s an indicator, not an appraisal. It can work in reverse as well, for investors looking to buy property:

### Value (purchase price) × cap rate = net operating income

Let’s take a look at how these numbers work together to present investors with a bigger picture.

## Fixed and Operating Expenses

Let’s talk about **operating expenses** first. Why do we care how much it costs to hold, service, and maintain an investment property? Because we can count these expenses as deductions against our taxable income. All expenses relating to the operation of the investment property are deductible expenses. Some examples of operating expenses include:

- Maintenance
- Utilities
- Supplies
- Advertising
- Legal/accounting
- Wages and salaries
- Property management

In addition to the above, it’s also necessary to take into account fixed expenses such as property insurance, property taxes, and licenses and permits.

## Gross Income

Gross income is the income received before the operating expenses are deducted. If investors were taxed on gross income, there would be a lot fewer investors. You should also understand the difference between* potential gross income* and *effective gross income*.

Potential gross income is income that a property could bring in if it were leased at full capacity. That rarely happens, so once losses from vacancies and credit losses (such as when tenants do not pay their rent and it becomes uncollectible) are deducted from potential gross income, you get effective gross income, or, more simply, gross income.

*For example:*

**Potential gross income – vacancy and collection loss + other income = effective gross income**

So, for instance, if ACME Properties is fully leased, it generates $252,000 in potential gross income. Assuming a fully leased property and deducting for vacancy and losses of $10,895, and assuming there’s no additional income, ACME Properties’ effective gross income is $241,105.

## Net Operating Income

Once you deduct operating expenses from effective gross income, you get net operating income. Are investors taxed on net operating income? No! Investors may also be able to apply allowable interest deductions from their mortgage payments. Mortgage principal and interest payments are called debt service.

When you apply interest deductions to net operating income, you arrive at net taxable income. Depending on the property’s depreciation allowance, depreciation can sometimes effectively cancel net taxable income, resulting in no taxes owed.

*For example:*

**Effective gross income – operating expenses = net operating income **

So, for instance, if ACME Properties’ effective gross income is $241,105, and we subtract $11,560 in operating expenses, the net operating income is $229,545.

## Capitalization Rates

Capitalization rate (or cap rate, for short) is determined by the market. It’s the return on investment that other investors in a given marketplace are receiving for a similar property. So, if the going cap rate is 7% (which is 0.07), then the capitalization formula would be to multiply 0.07 by the value (purchase price of the property) to get net operating income.

**Value (purchase price) × cap rate = net operating income**

$200,000 × 0.07 = $14,000 net operating income

If, instead of the cap rate, you know the annual income and value, you can determine the cap rate by dividing the income by the value:

**Net operating income ÷ value = cap rate**

$14,000 ÷ $200,000 = 0.07, or 7%

So, let’s say investor Jimmy is looking for an investment property in an up-and-coming area of town. He found one that meets all his requirements. The list price is $800,000, and similar properties in the area are returning a rate of 9%. To figure out his net operating income, Jimmy must multiple the value of the property with the cap rate.

$800,000 x 9% = $72,000

## Formula Factors

The factors in the formulas are generally referred to as “I” for income, “R” for rate or cap rate, and “V” for value.

**To determine income:** Multiply cap rate by value (R × V = I)

**To determine value:** Divide income by rate (I ÷ R = V)

**To determine rate (cap rate): **Divide income by value (I ÷ V = R)

**Cap Rate Example**

– A property valued at $950,000 is returning a net annual income of $115,000.

– $115,000 divided by $950,000 is 12.1%.

– The cap rate is 12.1%.