NOI CALCULATION
NOI stands for Net Operating Income and its calculation is discussed in this article in detail.
The NOI calculation is necessary for the estimation of a number of investment performance and risk metrics, such as the initial yield/income return/capitalization rate, the internal rate of return, cash-on-cash return. An important risk measure that is always calculated when financing property investments through mortgage loans is the debt coverage ratio, which indicates how much higher is the NOI produced by the property from the mortgage payment required to repay the loan per the terms of the mortgage contract.
The initial yield/capitalization rate is calculated as the ratio of the property’s NOI over its purchase price and, therefore, it reflects the income produced by the property as percent of its total value price. That is why it also represents what is referred to as the income return for that period. However, note that this measure does take into account any increases in value which would result in a higher investment return or decreases in value which would result in a lower investment return. Notice also that this ratio represents also the capitalization rate, which actually represents the relationship between price and income in the sense of a required return by the investor, which determines the ultimate transaction price that an investor will accept.
The internal rate of return (IRR) measures the periodic total (not just income) return over the expected holding period. For the calculation of this performance measure, we need to continue from the NOI calculation to the calculation of the after-tax cash flow of the property, on the basis of which the IRR is typically calculated.
The NOI is also a required input in calculating the cash-on-cash return which is actually the ratio of the NOI over the investor’s funds (equity) used for the acquisition of the property.
Finally, the Debt Coverage ratio is calculated as the ratio of the property’s annual NOI over the annual mortgage payment required to repay the mortgage loan that is used to finance the acquisition of the property. Obviously if this ratio is lower than 1 it means that the NOI is not sufficient to cover the mortgage payment.
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