Net Operating Income and Why it Matters
The commercial real estate industry is one of the most profitable and growing industries out there. Though there are risks involved, those with sufficient knowledge about the industry have higher chances of being successful on their investments. One of the things that an investor must understand before investing in commercial real estate is Net Operating Income (NOI). It is a fundamental measurement when it comes to investing in commercial real estate. It is commonly referred to as NOI. It is simply impossible to fully understand investing in commercial real estate without having a firm grasp on NOI.
How NOI is Calculated
NOI is the annual income that is generated by an income-inducing property which is calculated by deducting expenses incurred from operations from the total revenue.
In order to calculate NOI, you will need the potential rental revenue, vacancy and other revenue. Take the potential rental revenue and deduct the vacancy to get the effective gross income (EGI). Add the other revenues to the effective rental income to get the gross operating revenue. From the gross operating revenue, deduct the operating expenses to get the Net Operating Income (NOI).
Net Operating Income (NOI) = Effective Gross Income (EGI) – Operating Expenses
The procedure of calculating the net operating income is quite clear once you break down each of the individual components. As mentioned earlier, there are four components of the NOI:
· Potential rental income
· Other revenue
· Operating expenses
Potential Rental Income
The Potential Rental Income (PRI) is the total of all rents under the terms of each lease while making the assumption that the property is 100% occupied. When the property is not fully occupied, a market-based rent is used based on lease rates and terms of comparable properties.
Vacancy is subtracted by the PRI because either the property is currently leasing up or tenants are vacating the property. While calculating the NOI, the vacancy factor can be estimated based on current lease expirations as well as market driven figures while using comparable property vacancies.
Properties may derive revenue from other sources besides rents or leases. Other sources of income could be billboards, signage, parking, laundry, and vending among other activities that can generate additional income.
Effective Gross Income
Effective Gross Income, EGI, is the gross potential revenue less the vacancy. It is the amount of rental income that the owner can expect to collect.
Operating expenses include all expenses needed to operate the property and consist of items such as marketing & advertising, salaries, management fees, repairs & maintenance, utilities, property insurance, and property taxes. There are also usually some other miscellaneous expenses like legal fees and accounting.
Net operating income
The result after deducting the operating expenses from the Effective Gross income (EGI) is now the net operating income.
NOI is positive when operating revenue exceeds the gross operating expenses. In the same manner, it is negative when operating expenses exceed the gross operating income. NOI can cover any period of time, but is most commonly shown as one fiscal year. When it comes to commercial real estate analysis, the NOI can be based on either historical financial statement data or forward-looking estimates for future years, which is also known as proforma.
Net operating income is a measure of a property’s ability to produce an income stream from operation. It is not like the cash flow before tax figure which is calculated on a typical real estate proforma. The NOI is different in that it excludes any financing or tax costs incurred by the owner or investor. In simpler terms, the net operating income is unique to the property and not the investor.
Exclusions in net operating income
If you have noticed, there are several expenses that are typically excluded from NOI.
· Debt service - Financing costs are specific to the owner or investor hence they are not included on the NOI as they can vary from property to property.
· Depreciation - While great for tax purposes, depreciation is not an actual cash outflow. Rather, it is an accounting entry hence not included in the NOI calculation.
· Income taxes - Income taxes are specific to the owner or investor. They should not be included in the calculation of the NOI.
· Tenant improvements - Tenant improvements are construction within a tenant’s usable space to make it viable for his or her specific use. Commonly denoted as TI, tenant improvements are excluded from calculation of NOI.
· Leasing commissions - Leasing commissions are the fees paid to real estate agents and brokers who were involved in the process of leasing the space.
· Replacement Reserves – replacement reserves are monies set aside for future maintenance items that may be needed such as roof replacement, repair of air conditioning and other such maintenance costs. In the textbook definitions of ROI, the reserves are usually excluded from calculation, but many analysts do include them in practice. For instance, lenders include reserves in NOI calculation when determining debt services coverage and the maximum loan amount. For a lender, this makes a lot of sense because he or she needs to know the ability of a property to service debt, which has to take into account the required capital expenses to keep the property competitive in the market. As such, replacement reserves can do go either way when it comes to NOI calculations.
Capital expenditures - These are expenses that occur irregularly because of major repairs or replacements. They are usually funded by replacement reserves. Capital expenditures only include the major maintenance costs such as replacing the roof or HVAC system in a property. It does not include the minor repairs considered as operating expenses like painting a door.
As shown above, some items are open for interpretation as to whether they should be included in NOI calculations or not. That being said, NOI is standard calcuation which is mostly fixed as it is used broadly across the commercial real estate industry.
Net Operating Income and Leases
One important item to note is that certain lease agreement can increase or decrease the number of items found in NOI calculation. Lease agreements identify both the main source of income as well as who pays for what expenses. Although the lease agreement doesn’t change the NOI calculation, it does specify if the lessee or the lessor pays for property taxes, for example. If the lessee pays for property taxes, then property taxes should not be included in the NOI calculation on the property as the investors of that property do not bear the burden of that operating expense.
There are several different real estate leases such the modified gross lease, the triple net lease or the full-service lease. All these leases have various meanings depending on who you are talking to and which part of the world you are dealing with. Therefore, it is important to read and fully understand the structure of each lease.
Leases structures are a sort of spectrum of possible structures. On one hand there are absolute gross leases where the owner pays all the operating expenses related to property and on the other hand, you have the absolute net leases where the tenant is expected to pay all the operating expenses. All the other leases fall in between these two extremes and can be considered as a negotiated or hybrid lease.
How to interpret net operating income
Investors and other stakeholders use NOI to get an understanding of the cash flows generated by a property. Why? Because it is difficult to manipulate the NOI. Net operating income can change only by increasing rental income or by decreasing operating costs.
The NOI is a widely used measure because it excludes financing and income tax considerations thus it is great for evaluating how well a property is being managed. Take for instance the operating margin. This is obtained by dividing the NOI by the potential rental income. The operating margin can be directly compared across similar properties.
The importance of net operating income
By now, you should have a rough idea on why the NOI is so important. Calculating the NOI is crucial in evaluating and valuing a property.
Net operating income also provides a basis for the calculation of other indicators in the real estate industry like the cap rate or maximum loan analysis.
NOI is extremely useful in trend analysis. An analysis of how NOI of a property has changed in recent years is a good indication of how viable an investment in that project would be. If the NOI has been declining, it is red flag that there is a need for remedial action.
Lenders greatly prefer properties with high NOIs because this reduces the lender’s probability of default. The NOI helps to determine the debt service coverage ratio (DSCR), the maximum loan, as well as the borrower’s creditworthiness.
When you are getting started as a commercial real estate investor, understanding NOI is a key place to start. Make sure you understand the NOI and how it is calculated before you make any investments. Know what is included in the NOI calculation and what is excluded. With this information, you will have an adequate framework to understand NOI and be able to invest with confidence.
ABOUT THE AUTHOR
Ken has been in the real estate business for over 40 years and has personally overseen the development and management of over $350 million worth of assets. Ken holds a B.S. degree in Accounting from Brigham Young University, a MBA from the University of Utah. Licensed real estate broker since 1976. He holds the following designations: CCIM, CPM, CRS,CCA. Served as the president of the Utah Apartment Association.