Net Operating Income
The Net Operating Income (NOI) is one of the most important figures when analyzing the return potential of income producing properties, such as commercial properties or rental residential properties.
The major reason for this is that one of the major methods used by industry professionals to determine the value of the commercial property is the income capitalization approach, according to which the value of an income producing property is equal to:
Value = Net Operating Income / Market Capitalization Rate
Thus, if the Net Operating Income of a property and the market capitalization rate is known it can allow for a quick and rough estimate of the value of the property. The market capitalization rate (or cap rate) is calculated by evaluating data pertaining to recent actual sales transactions of the property type under consideration in the local market.
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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 it’s operating expenses and mortgage payments. A debt coverage ratio below 1 indicates that the income produced by the property is not sufficient to cover operating expenses and debt payments, while a debt coverage ratio above 1 indicates that such expenses are covered. Most lenders require a minimum DCR of 1.1 to 1.3 when providing commercial property loans. From a a bank’s perspective, the larger the debt coverage ratio, the better. The formula for the DCR is:
DCR = Net Operating Income / Debt Service
The NOI and debt service used in the above formula refer to annual numbers. Thus the debt service is the annual payment due the lender per the loan contract.
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.
Net Operating Income Formula
This is an excerpt from the e-book Real Estate Return MathematicsNOI = 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 Plus Utilities Plus Supplies Plus Marketing Plus Maintenance and Repairs Plus Security Plus Salaries Plus Administration Plus Property Taxes
Example (continuing from previous): Market Price = $1,000,000 Effective Gross Income = $120,000 Operating Expenses = $35,000 Recoveries = $15,000
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.
Important Components of Net Operating Income
From the formula above it is clear the most important components of the NOI calculation are the Gross Effective Income and operating expenses. The most important determinant of the former are the rents paid by the tenants of the property and the escalation clauses in the lease contracts that determine how much the rent that each tenant pays will increase each year. Equally important is the property's occupancy rate, that is what percent of the total space in the building is occupied by tenants. 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 market rents will be higher and the time that will take to lease the vacant units is shorter. If the market is soft 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.
Shopping Center Net Operating Income
Net operating income and all items that enter the DCF model are discussed extensively in one of the best and most comprehensive books on real estate investment analysis for commercial properties, which is the book written by Geltner and Miller, two of most distinguished minds in the real estate academic community. Their book bridges the gap between mainstream finance and the current cutting edge of professional real estate practice.
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
- Percentage rent
- Common area income
- Food court income
- Real estate tax income
- Tenant charges including utilities
- Temporary tenant income
- Miscellaneous 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
- Housekeeping
- General building maintenance
- Landscaping
- Security
- Trash removal
- Snow removal
- Parking lot maintenance
- Payroll
- Insurance
- Fees for professional consultants
- Utilities
- Real estate taxes
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