People love real estate investing - probably because you can earn an income and you can easily borrow money to buy the real estate.

First, I should clarify that real estate is not one thing. You get different types:

• Residential – homes, duplexes, townhouses, multifamily complexes.

• Commercial – shops, hospitals, hotels, parking lots, offices.

• Industrial – factories, distribution centers, warehouses.

• Land – undeveloped land, farms, forests.

• Special purpose – cemeteries, schools, places of worship.

Whatever type you’re talking about, RE investors have their own language. Yes, they call themselves RE investors - where RE is obviously short for real estate. Let’s decode their investment language and how they do things.

Net operating income

The first bit of lingo to understand is the Net Operating Income or NOI. The NOI is the rental income if the property were fully occupied, less expenses.

Capitalization rate

The capitalization rate (or cap rate) is the NOI in year 1 divided by the value of the property.

With property valuation, people generally compare sales in the area and then value their property using those “comparables”. To get the cap rate in your neighbourhood, you can find out the NOI and divide it by the value of a comparable sale.

For all you stock market investors, these formulas should seem familiar. If you replace NOI with earnings, and property value with share price, you get the earnings yield ratio.

The reciprocal of the earnings yield is the Price-to-Earnings ratio (or PE ratio).

Valuing a property

If we rearrange the cap rate formula, we can use it to calculate the value of a property.

If the net operating income from a property is 240,000 and the cap rate is 8%.

Value = 240 000 / 8%

Value = 3 000 000

This will also seem familiar to stock market investors. Dividing earnings by earnings yield is equivalent to multiplying earnings by the PE ratio:

Share price = Earnings x PE ratio

Conclusion

As it turns out real estate uses the same methods that stock market investors use for valuation. They just have different names for it. So next time a RE guy starts talking about NOI and cap rates, think earnings yield and PE ratio.

Want to work out the value of your home?

As an estimate, take your bond interest rate for the cap rate and use rental income (minus expenses) in your area as the NOI:

Property value = NOI / cap rate

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