The Use of Net Operating Income (NOI) in Commercial Real Estate Valuation and the Importance of Its Value
Commercial Real Estate. Calculation of Net Operating Income
The value of commercial real estate is determined by its net operating income (NOI). Let’s walk through a simple example of how to establish a property’s net operating income before getting into the relevance of NOI, the role it plays in both short-and long-term value, and how to assess NOI.
Revenue – $1,000,000
Expenses – $400,000
= Net Operating Income (NOI) – $600,000
Capital Expenditures – $100,000
Debt Service – $250,000
= Net Cash Flow -$250,000
The following formula determines a property’s NOI, as shown in the table:
Revenue minus expenses equals net operating income.
What Is the Importance of Net Operating Income?
The two main components of NOI, revenue and expenses, will be discussed for the majority of this paper. However, before we get there, there’s something that newcomers to real estate research and value sometimes overlook. Capital Expenditures (CapEx) and Debt Service are line items in the table above, underneath NOI (DS). The Net Cash Flow (NCF) of a property is calculated by subtracting these items from the NOI. The NCF indicates the actual cash flow to an investor after any substantial renovations are paid for and the mortgage payment is made each month or year. It makes sense to use the NCF to value a home because that’s what shows how much money an investor will get from it.
The basic answer is that the NOI is an objective number that indicates the property’s “market-based” operation, which means that the occupancy rate and lease rate that determine revenue and expenses are mostly determined by the market. Capital expenditures and debt service, on the other hand, are more subjective and specific to particular property owners. For example, one owner may believe that low leverage (a smaller loan amount) is better for their investment criterion than a riskier investor. As a result, even though the property generates the same NOI, the debt service payments will likely be lower, and the NCF will eventually be higher for each investment. The same can be said for capital expenditures. If we utilize NCF for valuation, if one investor chooses to invest more in refurbishment and upkeep than another, the NCF will be lower and the valuation will be lower. It doesn’t seem fair to value a house that has been well-kept at a lower price than one that has not.
As a result, the industry norm for property valuation is to employ the NOI. It takes a lot of the subjectivity and variances in investor profiles out of property appraisal.
Another important method for valuing commercial real estate is to calculate cap rates; for more information, see our article “What is a Cap Rate?” Major Components of Net
Now we’ll look at the two key factors of NOI: a property’s revenue and expenses.
All payments generated by tenants or consumers to the property owner are referred to as revenue. Lease payments, reimbursements for expenses, and other sources of income are frequently included. Each property type (office, retail, multifamily, etc.) has its own unique sources of “other income,” which we’ll just touch on briefly in this article because this item accounts for a small percentage of most properties’ revenue. Although there are several potential revenue streams, we will just address a few of the most important ones in this paper.
Payments on the Lease
The majority of properties’ revenue comes from lease payments. Leases for office, retail, and industrial properties often last five to ten years and include a “base rent” figure that defines how much the tenant pays per square foot of space per year. Tenants in multifamily properties pay a set amount of rent each month.
Reimbursement of Expenses
Only office, retail, and industrial properties normally receive expense refunds. The owner will be reimbursed for all or part of the expenses incurred during the operation of the property by the tenants. Real estate taxes, power, water, and possibly other utilities could all be included in these costs.
Other Sources of Income
As previously stated, other income often accounts for only a very small fraction of a property’s revenue. Other sources of income for multifamily homes could include laundry, furniture rental, or a subscription to the property’s fitness center. Some other sources of income for office, retail, and industrial buildings that rent parking spaces, rent space on the roof for communication equipment, and hire cleaning people are:
Although vacancy is not a source of income, any unoccupied space that is not getting lease payments reduces the amount of money a property owner could collect. We’re merely noting it because job openings can appear in two distinct ways, which you should be aware of if you come across one. Some real estate professionals include “Gross Potential Rent” and then remove lost money from vacant space to get at “Net Rental Revenue,” whereas others simply utilize the amount of revenue actually collected. The Gross Potential Rent and Vacancy method is the more formal approach, but you should always double-check to make sure.
Vacancy Loss Is Incorporated
Commercial real estate property operating expenses are a little easier to calculate than revenue. The following is a list of typical property expense items.
For larger properties, there may be many additional sorts of expenses and even subcategories of expenses within each main category. Expenses can’t be fully looked at because this article isn’t long enough. But you need to know that each property should be thoroughly checked for any and all expenses that the owner might incur.
Now that we know what NOI is, why it’s important, and what the main parts of NOI are, we can go into more detail and look at each one to figure out how much a property might be worth in the short and long term.
What Role Does Net Operating Income Play in Valuation and Return?
As previously stated, Net Cash Flow (NCF) is the investor’s ultimate cash flow, whereas NOI is the income before capital expenditures and debt payments are removed. While this is true, an investor’s return is determined by the amount of revenue generated by the property rather than the optimization of expenses and debt service. For example, if rental revenue declines by half as a result of the loss of a key tenant, it’s doubtful that NOI or NCF will be positive, despite some minor cost-cutting measures. Similarly, if the market experiences decreasing rental rates and/or occupancy rates, an owner may witness a progressive reduction in NOI and NCF over time, eroding both the cash flow and the property’s long-term worth. As a result, it’s critical to consider a few aspects that will influence the property’s performance during the holding period.
Expirations of Leases
When looking at a property’s rent roll, keep an eye out for lease expirations. Because most multifamily property leases are for one year, this isn’t a significant factor. Almost every commercial property (office, retail, and industrial) will have leases that expire throughout a five-or ten-year hold period, but an analyst should be aware of any major tenant expiration or concentrated rollover (meaning multiple tenants with lease expiration at roughly the same time). The loss of a key tenant, or numerous tenants at once, could have a significant negative impact on the property’s NOI, limiting the owner’s capacity to fund expenses and debt service.
Another important issue that an analyst should be aware of is the overall orientation of the real estate market as it relates to the subject property. Revenue and NOI will likely decline over time if an investor plans to keep a property for ten years in a market where rental rates and occupancy rates are dropping (and are expected to keep dropping). This will lower the value of both the property and its return on investment.
In this study, we looked at the components of the NOI of properties as well as some of the factors that influence the NOI. We’ve also looked at how NOI influences a property’s value as well as the long-term return an investor might expect. Every property is unique, with its own mix of tenants, income, and expenses. There are a lot more things that real estate professionals know about each property and how changes to the NOI over time will affect the long-term value of each one.