Capitalization (cap) rates workout number one. You are considering buying an office building which has stabilized rents. Using the information below, calculate the cap rate. So we have our office building asking price of 3.5 million. We have some revenue and expense data. And the first thing that we're going to have to do is calculate the net operating income for this building. So we will begin by taking the revenue, the rental revenue from the building, 500 and we will add to it the parking lot revenue. We will then subtract the property operating costs as well as the property taxes. We will exclude the depreciation because that's non-cash. We will exclude the REIT management overhead because that is not an expense that is associated with this particular building but rather the REIT structure as a whole. And we will exclude the interest on the mortgage because net operating income needs to be an unlevered earnings or cash flow metric. So we can copy that formula from year zero into projected year one and we have our net operating income.

To calculate the cap rate we have to take the net operating income from the projected year one and divide that by the office building asking price of 3.5 million and that gives us a cap rate of 7.8%. Remember that it is critical that we use the net operating income from the projected year one and not the current year.