The first question out of my mouth when someone is presenting a deal to me is:
“What’s the current net operating income (NOI)?”
Net operating income is the amount of income that a property is throwing off after all operating expenses like property taxes, insurance, utilities, property management fees, and maintenance are considered, but before debt service and income taxes.
Here is a simple net operating income formula:
Net Operating Income (NOI)
Gross Income – Operating Costs = Net Operating Income
Now that you know NOI calculation, let’s go a few levels deeper. You have gross scheduled income, gross operating income, and net operating income on your income statement. The gross scheduled income is what you should make on a property if you have no vacancy or credit loss. The total income a property actually takes in after considering vacancy and credit loss is the gross operating income. Once you deduct the operating expenses you are left with the net operating income. If you have a negative NOI that is a Net Operating Loss.
The reason we do not initially look at post debt service cash flow is that the capital stack on each deal is different. Someone may purchase a commercial property all cash. Another investor may use 100% debt financing. Others may be somewhere in the middle. The point is every deal and every investor is different. NOI is the universal starting point that shows real estate investors how much operating income the property is currently producing. The true value of the asset in the marketplace is derived from its NOI.
In value add real estate investment, understanding net operating income is an important metric we evaluate when analyzing a property, but it does not tell the whole story. What is even more important is how much we can increase the NOI of a particular asset through our own doing. There is a myriad of ways to boost the NOI on your financial statements. You can raise rental income, introduce vending machines, billboards, tenant improvement, and other additional income, or find opportunities to reduce operating costs. Your potential rental income will be an important part of your strategy as you move forward with the property you are acquiring.
Additionally, NOI alone does not tell you the current value of an asset. $500,000 in NOI looks very different on a $5mm deal versus a $25mm deal. Your capital expenditures are not considered in your NOI. If you purchase an investment property that will have some expensive updates needed in the first few years, make sure you are calculating that in during your underwriting as it can massively affect your projections if not considered upfront.
Let’s talk about the capitalization rate (Cap Rate) next time, so you can understand how all commercial real estate is valued in the marketplace.