How do you analyze a real estate investment? What's the role of cap rates, NOI, and DCF?
CFA Level II covers real estate valuation and I'm getting confused by all the metrics — cap rate, NOI, cash-on-cash return, DCF. Which approach is primary, and how do you actually decide if a property is a good investment?
Real estate valuation uses multiple approaches, but they all revolve around Net Operating Income (NOI) and cash flow analysis. Here's a structured framework.
Net Operating Income (NOI):
NOI is the foundation of all real estate analysis:
NOI = Gross Potential Rent - Vacancy Loss - Operating Expenses
Important: NOI does NOT include debt service (mortgage payments), depreciation, or capital expenditures. It represents the property's operating profitability before financing decisions.
Approach 1: Capitalization Rate (Income Approach):
Property Value = NOI / Cap Rate
The cap rate is the required rate of return on the property, derived from comparable sales:
Cap Rate = NOI / Sale Price (from comparable transactions)
Example: An office building generates NOI of $720,000. Comparable office buildings in the area sell at cap rates of 6.5%.
Value = $720,000 / 0.065 = $11,077,000
Lower cap rate = higher value = more expensive market.
Approach 2: DCF Analysis:
Project cash flows over a holding period (typically 5-10 years), estimate a terminal sale price, and discount everything back.
Approach 3: Cash-on-Cash Return (Levered Analysis):
Cash-on-Cash = Annual Before-Tax Cash Flow / Total Cash Invested
This measures the return on YOUR invested equity, accounting for mortgage payments:
Before-Tax CF = NOI - Debt Service
Example: You buy a property for $2M with $500K down payment. NOI = $140,000. Annual debt service = $95,000.
Before-tax CF = $140,000 - $95,000 = $45,000
Cash-on-cash = $45,000 / $500,000 = 9.0%
Notice the leverage amplification: unlevered return (cap rate) = 7.0%, but leveraged cash return = 9.0%.
Valuation Decision Framework:
| Metric | Purpose | Decision Rule |
|---|---|---|
| Cap Rate | Quick valuation & comparison | Buy if cap rate > required return |
| DCF NPV | Comprehensive value analysis | Buy if NPV > 0 at required return |
| Cash-on-Cash | Equity return measure | Compare to alternative investments |
| IRR | Total return with leverage | Buy if IRR > hurdle rate |
Key Risks:
- Vacancy risk: Anchor tenant departure can devastate NOI
- Interest rate risk: Rising rates increase cap rates (lower values) AND increase financing costs
- Illiquidity: Can't sell quickly without a significant discount
- Concentration: Single property = undiversified
Practice real estate valuation problems in our CFA Level II question bank.
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