Understanding Cap Rates and NOI, With a Local Example
If you own or are thinking about buying an income property, two numbers come up in almost every conversation: net operating income (NOI) and the capitalization rate (cap rate). They’re simple ideas, but small mistakes in how they’re calculated can move a price by hundreds of thousands of dollars. This article walks through both with a worked example based on a typical small retail center in our area.
Net operating income
NOI is the property’s annual income after operating expenses but before debt payments, income taxes, depreciation and capital improvements:
NOI = Effective gross income − Operating expenses
- Potential gross income: all rent the property would collect if fully leased, plus expense reimbursements from tenants (on NNN leases) and other income such as signage or storage.
- Vacancy and credit loss: an allowance for space that will sit empty and rent that won’t be collected. Even a fully leased building should carry one, because leases end.
- Effective gross income (EGI): potential gross income minus vacancy and credit loss.
- Operating expenses: property taxes, insurance, common-area maintenance, utilities the owner pays, management, repairs, and usually a reserve for replacements (roof, parking lot, HVAC).
What NOI does not include: mortgage payments, the owner’s income tax, and depreciation. Those depend on the owner, not the property.
Cap rate
The cap rate converts one year of NOI into a value:
Cap rate = NOI ÷ Price, so Value = NOI ÷ Cap rate
Freddie Mac’s cap rate guidance describes it the same way: a rate used to convert expected NOI into an indication of value. A lower cap rate means buyers are paying more for each dollar of income, usually because they see the income as safer or expect it to grow. A higher cap rate means more perceived risk or less expected growth.
Cap rates are a shorthand, not a full analysis. They capture one year of income and say nothing directly about lease terms, upcoming vacancies or major repairs. The Texas A&M Real Estate Research Center makes this point in its article on accurate commercial valuation: direct capitalization is popular and straightforward, but only as good as the income estimate and market cap rate that go into it.
A worked example: a small strip center
The figures below are hypothetical, chosen to illustrate the math. They are not market data for any specific property.
Picture a 6,000-square-foot, four-unit retail strip on a busy road in Lumberton or north Beaumont, with each unit leased on NNN terms.
Step 1: Income
- Base rent: 6,000 SF × $16.00/SF/yr = $96,000
- NNN reimbursements from tenants (taxes, insurance, CAM): 6,000 SF × $5.00/SF = $30,000
- Potential gross income: $126,000
- Less vacancy and credit loss at 7%: −$8,820
- Effective gross income: $117,180
Step 2: Expenses
- Property taxes: $14,000
- Insurance (wind and flood included): $9,500
- CAM (parking lot, lighting, landscaping, trash): $6,500
- Management (4% of EGI): $4,687
- Non-reimbursable repairs: $2,000
- Replacement reserve ($0.25/SF): $1,500
- Total operating expenses: $38,187
Step 3: NOI and value
NOI = $117,180 − $38,187 = $78,993
At an 8.0% cap rate: $78,993 ÷ 0.080 ≈ $987,000
At a 7.5% cap rate: $78,993 ÷ 0.075 ≈ $1,053,000
At an 8.5% cap rate: $78,993 ÷ 0.085 ≈ $929,000
A half-point change in cap rate moves the value by roughly $60,000 on a property this size. That’s why both the NOI and the cap rate deserve scrutiny.
Where the numbers go wrong
- No vacancy allowance. A seller’s “actual” NOI from a year with every unit occupied overstates what a buyer should expect over time. Small centers lose a tenant now and then, and re-leasing takes months plus commissions and improvements.
- Old insurance numbers. Property insurance on the Gulf Coast has risen sharply. Underwrite with a current quote, not the seller’s policy from two years ago.
- Taxes reset after a sale. In Texas the appraisal district values property at market value each January 1, and a recent sale price is strong evidence. If you pay more than the current appraised value, expect the taxes to rise. Look up the account on the Jefferson CAD or Hardin CAD site and estimate taxes at your purchase price.
- Expenses the leases don’t actually pass through. Read every lease. “NNN” on a rent roll sometimes turns out to have caps, base years or exclusions that leave the owner paying part of the costs.
- No reserves. Leaving out a replacement reserve makes NOI look better until the roof needs replacing.
- Pro forma vs. actual. A “pro forma” cap rate based on projected rents after leasing up the vacancies isn’t the same as the cap rate on today’s income. Know which one you’re being quoted.
What drives cap rates
Cap rates differ by property type, location, building age, tenant credit and lease length. A new single-tenant building leased long-term to a national company will trade at a lower cap rate than an older multi-tenant strip with local tenants on short leases, even in the same town. Interest rates matter too: when borrowing costs rise, buyers usually need higher cap rates to make the numbers work. In fall 2026, with the 10-year Treasury near 5%, CBRE noted that the gap between average cap rates and Treasury yields had narrowed to an unusually thin margin, as reported by CRE Daily.
Smaller markets like Beaumont–Port Arthur have fewer sales than Houston, so published national cap rate surveys aren’t always a good guide. Recent local sales of similar properties, adjusted for lease terms and condition, are the better benchmark.
Beyond the cap rate
Serious investors also look at cash-on-cash return (cash flow after debt service divided by the cash invested), debt service coverage (NOI divided by annual loan payments, which lenders use to size loans), and a multi-year cash flow that accounts for lease expirations, re-leasing costs and an eventual sale. The cap rate is the start of the analysis, not the end.
If you’d like a second opinion on the NOI of a property you own or are considering, or you want to see what’s currently for sale, browse our investment listings or get in touch.
This article is general information, not legal, tax or investment advice. Consult a qualified professional before buying or selling property.
Header photo: CropBEAUMONTps by Reagan Rothenberger, licensed CC BY 3.0, via Wikimedia Commons.
