Net Operating Income (NOI) seems to be the buzzwords that people talk about when they are talking about a particular real estate investment. I just wonder if most people know what it is or how to calculate it? In either case, it is one of the most important things to consider when investing in real estate.
NOI is the residual that is left after you take the operating income (rents, laundry money, fees) and subtract out the operating expenses (taxes, insurance, maintenance, management, etc.). Investors sometimes make mistakes when considering what should be included in the operating expenses. Because the value of commercial real estate is established by using the NOI, including items that should not be in there is detrimental. Novice investors make two very common mistakes:
1. They Include Debt Service: Investors should not be including their debt service, or annual mortgage payments in their operational expenses. Mortgage debt is not an operational expense and if included minimizes the NOI which could lead ultimately to a lower value.
2. They include Capital Expenditures: Capital expenditures are basically “one time” costs that are not included in the operations of the asset. One time costs are things like new windows, a new roof, or a new parking lot. By including capital expenditures in the operating expenses you are lowering the NOI, hence lowering the value.
NOI is important in analyzing properties because it is used directly or indirectly in some key formulas. Formulas such as Cap Rate, Cash Return on Investment, Total Return on Investment, and Debt Service Coverage Ratio all use NOI in some form or fashion. It is not only used in establishing value, but also in building strategies to increase value.
Increasing value in real estate, on purpose, is called forced appreciation. When you force the appreciation on an asset you are doing specific things to drive its value. In commercial real estate that is done by increasing the NOI and there are only two ways to do that.
One, raise the overall income by raising rents, fees, etc… Two, you can lower expenses. In either case, you increase NOI. It is something that investors need to continually do throughout the life of the asset. If you focus on NOI you will not only increase the value of the property, but increase your cash flow as well.
When looking at NOI of a property that you are considering buying, I would analyze for the previous three years. Make sure that you look at the trends with the NOI, such as, is it increasing or decreasing and why. Make sure you look at the strategies that you are going to be using to increase the NOI compared to what was done historically at the property.
Finally, look at the NOI of properties that have sold in your area of focus. Notice the things that make up the NOI with those properties compared to how you will operate yours. NOI is the sleeping giant of real estate facts. Make sure you don’t under estimate how important it is!