Let's say you're an investor looking to buy an apartment building—It's a simple calculation to see if the asking price equates to a solid investment.
Obtain the CAPITALIZATION RATE by dividing the NOI (net operating income) by the ASKING PRICE.
The higher the "cap rate" the better your return on investment.
In this example, you are looking for a 7-10% cap rate.
The NOI is calculated as follows: $1750 annual rent x 12 months x 3 units = $63,000.
Subtract $4,600 for yearly building expenses (real estate taxes, water, repairs).
NOI = $58,400
If the ASKING PRICE for this three-unit building is $595,000, did you get the 7-10% you were looking for?
CAPITALIZATION RATE = .098 = 9.8%
Yes! The 9.8% cap rate is well within the 7-10% cap rate you were looking for!
Using this diagram/formula one may conversely substitute an unknown value if the other two are known to obtain what the price should be, or necessary rent to make an investment work.