An investor looks at a property listed for $150k, with a monthly net operating income of $1k. He decides instead to offer $120k. What kind of income approach analysis would he have used to arrive at that conclusion?

• A. Gross operating income multiplier
• B. Capitalization rate
• C. Cash-on-cash return
• D. Debt service coverage ratio

Answer: (B)

Cap rate analysis focuses on turning income into value. The key idea is value equals NOI divided by the capitalization rate, or conversely, the cap rate equals NOI divided by value. Here the property’s annual net operating income is 12,000 (1,000 monthly times 12). If the investor is willing to offer 120,000 instead of 150,000, that implies an implied cap rate of 12,000 / 120,000 = 10%, higher than the 12,000 / 150,000 = 8% that the listed price would produce. So the price drop reflects applying a higher cap rate to achieve the desired return. The other options don’t fit: gross operating income multiplier uses gross income rather than NOI, cash-on-cash return looks at cash flow relative to cash invested (financing-influenced), and debt service coverage ratio relates NOI to debt service rather than setting a value.