As one technique to estimate market value, divide a property's net operating income (NOI) by the market capitalization rate (R). That estimated value figure can help you judge the merits of a potential investment, but it will not tell you the rate of return that you can expect to earn from a property.
Most investors make mortgage payments from their rents, so all of the NOI does not go into the investor's pocket. Nor does the cap rate measure the return on the amount of cash you invest (that is, the down payment). As a result, your return on investment will differ from the property's cap rate—and if you use leverage wisely, your rate of return will exceed the market-derived cap rate.
To figure investment returns (ROI), calculate the cash flows that remain after paying debt service.
Calculate before-tax cash flow (BTCF) as follows:
NOI less debt service (annual mortgage payments) equals BTCF
Return to the eight-unit apartment building example from Chapter 3. We calculated NOI for that property at $47,121. Applying an 8.5 percent market cap rate, we figured the property's market value as $544,365:
$544,365(V) = $47,121(NOI)/.085(R)
If you finance this property with a mortgage loan-to-value (LTV) ratio of 80 percent (20 percent down) at 7.5 percent interest, amortized over a term of 25 years, your mortgage and annual payments equal:
$544,365 (capitalized value).80 LTV$443,492 loan amount