NET OPERATING INCOME
The market capitalization rate (or cap rate) is calculated by evaluating data pertaining to recent actual sales transactions of properties comparable to the property under consideration in the local market.
The NOI is also necessary for the calculation of Debt Coverage Ratio or DCR, which provides to lenders and investors a measure of a property’s income-earning ability to cover both it’s operating expenses and mortgage payments. The DCR is a key measure used by loan officers in order to evaluate loan applications as it is an important risk indicator, especially when the borrower submits the income of the property as the only income source from which the loan will be repaid. In fact, in such cases, banks set a minimum DCR, which is above 1.2 usually, as a requirement for approving a loan amount.
The Net Operating Income is also a critical part of the Income Statement, Cash Flow Statement and return calculations. In particular it is important in estimating the Net Income Multiplier, and the internal rate of return (IRR) of an investment in a property. The formula for calculating the Net Operating Income of a property is the following: NOI = Effective Gross Income – Operating Expenses + Recoveries (4) Notice that typically commercial leases include clauses through which a significant portion of operating expenses is recovered from the tenants. Thus, the third term of Formula (4) represents the amount of operating expenses that is recovered from the tenants. Operating expenses are the sum of the following expenses: Management Fee
Example (continuing from previous): Therefore, NOI = 120,000 – 35,000 + 15,000= 100,000 and Net Income Multiplier = 1,000,000/100,000 = 10 Thus, in this example, the market price is 10 times greater than the NOI produced by the property.
If there is vacant space in the property then its effective rental income and its timing will depend on open market rents and the timing that it will take to rent the units. Notice that both of these variables will depend on how tight or soft is the market for rental space for the property type considered. For example, if the market is tight, which means that there is not too much space available in the market compared to the space demanded, rents will be higher and the time that it will take to lease the vacant units is shorter. If the market is soft, which means that there is lots of vacant space compared to the space demanded, then rents will be lower and the time needed to lease the vacant units will be longer. The analyst can use the most recent rental contracts that were signed within the year of analysis and an assessment whether the market is becoming softer or stronger in order to better estimate the rental rates at which vacant units will be rented, in order to produce projections of the property's net operating income over the holding period of the investment.
According to Don Paul in “Shopping Center Management” published by ICSC, the net operating income statement of a shopping center, includes typically only income and expense items occurring during the annual operations of the center. The income items include: - Rental income The percentage rent listed above is typical of retail leases and represents an agreed percentage of the tenant’s gross sales receipts, only if these exceed a pre-determined level. The expense items that are taken into account in building an NOI income statement for a shopping center include: - Administrative
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