Real estate professionals who serve investment clients should be familiar with all the different methods of valuation of income properties. One of these methods is the calculation of a property's net operating income (NOI). It's used with a capitalization rate to determine the value of a property.
Defining the Net Operating Income Metric
Net operating income serves as a way to analyze the viability of a real estate investment property. Finding a property's net operating income means figuring out how much money it brings in after covering all of its expenses and accounting for unrented time periods and expenses for maintenance and operations.
While NOI can change over time as the property's revenue and expenses fluctuate, lenders and creditors still find NOI to provide valuable information about whether the property earns enough income to support payments on its debt.
NOI can be affected by property owners who delay expenses because they're trying to make the property look more profitable. Likewise, the debt payments and interest expense don't factor into the NOI calculation, so it can be misleading unless you also factor in these necessary payments.
Calculating Net Operating Income
Determine the gross operating income (GOI) of the property. Use the following equation:
Next, determine the operating expenses of the property. It would include expenses for management, legal and accounting, insurance, janitorial, maintenance, supplies, taxes, and utilities. Subtract the operating expenses from the gross operating income to arrive at the net operating income as follows:
Net operating income = Gross operating income - operating expenses
For example, using a property with a gross operating income of $52,000 and operating expenses of $37,000, the net operating income would be ($52,000 - $37,000) = $15,000.
Commercial lenders use different qualification criteria to determine if a mortgage is warranted and how much they'll loan against a property. Investor owners usually aren't individually evaluated as to their credit history because it's not as important to the lender as the income generating potential of the property to be mortgaged.
A homebuyer is simply going to live in the home she's buying so the lender evaluates her ability to pay the mortgage and her history in paying debt obligations. It is a very different situation from a commercial property such as an office complex. The buyers are purchasing this property to generate positive cash flow from rental income.
When the motivation for the purchase is income, the lender wants to evaluate the property based mostly on the income it will generate. Of course, property condition and other factors enter into mortgage qualification as well, but income is the biggest factor.
A mortgage is likely to be initiated if the property can service the debt and meet the mortgage payments and still have an acceptable monthly income cash flow.
The Expenses Factor
Of course, expenses are one-half of the major considerations in the NOI calculation. It's critical to capture all the operating expenses of the property.
Depending on the property type, marketing, and advertising expenses can vary a great deal. Most of this expense for an apartment property would be advertising to generate tenant applicants. The same would apply to a retail or office property, but there might also be marketing expenses to present the property to consumers or clients for the tenants.
Professional management is the norm for larger commercial properties, and this expense can be significant. It can be offset somewhat, however, by the savings that professional management can generate in the operation and maintenance of the property.
Utilities should be included when they're not passed along to tenants. Everything from landscaping to fixing broken air conditioning units or painting of units should be included in repairs and maintenance. Don't forget insurance—this is a major expense as well. Other expenses can depend on the use of the property and the tenants.
Borrowers can come up with more cash for a down payment to bring the ratios into line if those wanted by the lender based on income aren't pointing to approval.
Missing expenses will increase net operating income, and your client will overpay for the property based on valuation using the cap rate.
Other investor calculations are often used as well. None are rocket science. You should be able to quickly get up to speed and perform them or discuss them intelligently with commercial investor clients.