Net operating income, or NOI, is used to determine a property’s profitability and ability to generate cash flow. It’s a crucial component in valuing a real estate investment. Good real estate managers have a business plan that creates value by increasing NOI. And investors who know how it works will have a better understanding of how investment firms generate that value and the decisions behind it.
How is NOI Calculated?
Simply put, a property’s net operating income is its revenue minus its operating expenses. NOI does not factor in capital expenditures, interest or taxes. So it is less subject to manipulation than other metrics: It allows an investor to consider a property solely from the perspective of income and profitability. Increasing both NOI and value generates a high equity multiple, which reflects the amount of money an investor gets back by the end of a deal. In its simplest form, the calculation could look something like this:
Why is NOI Important?
Simply put, NOI drives value. In fact, NOI is a crucial component in calculating the capitalization (cap) rate, which is the ratio of a property’s NOI divided by its purchase price or estimated value.
If NOI drives value in a property, that value in turn drives returns, which helps determine the feasibility of a project. This value can be shown through two other metrics: cash on cash and total return. Cash on cash, expressed as a percentage, measures the cash income earned relative to the cash invested and considers cash flow, which is NOI after mortgage costs are paid. In general, a higher percentage indicates a better investment. While the cap rate and cash-on-cash calculations are income-focused, the total return considers both income and appreciation. A property’s NOI is an important input no matter which metric being considered.
Biggest Drivers of NOI: Revenue and Expenses
As mentioned, NOI considers both revenue and expenses. Aside from rent, revenue can include inputs such as parking, storage, late fees and utilities, among others. With that total, adjustments such as vacancies, free rent and revenue forgone from non-paying tenants are calculated. Together, these variables equal effective gross revenue (EGR). To calculate EGR, take revenue, subtract any adjustments and add other income sources. EGR is important because only considering revenue can overstate value. And it comes in handy when comparing both NOI and operating expenses to typical standards or the overall market.
The second part of the NOI equation, expenses, involves many inputs and are typically either controllable or non-controllable expenses. Controllable expenses can be managed and shopped for—payroll, marketing, administrative, repairs and maintenance, and management fees. Non-controllable expenses can change independently; they include utilities, taxes and insurance.
The Operating Expense Ratio
With revenue and expense assumptions, the operating expense ratio can be determined. The expense ratio is calculated by dividing property expenses by EGR. And it can help determine if operating expenses are in line with other local properties and if there could be potential increases or savings down the line. It also helps indicate how the current manager is running the property. Together, they allow you to value the property appropriately and can point to potential efficiencies.
It is not enough to simply estimate one year’s worth of rental rates or expenses, however. The NOI analysis also involves estimating future expectations, and forecasting revenue and expense growth. Origin typically limits these estimates to five years, but standards can range from three to 10 years. Forecasting relies on many factors that require experience and resources. Having the market knowledge and experience to forecast appropriately, and recognize if a set of assumptions is achievable, is crucial when evaluating an investment opportunity.
NOI: Detailed Calculation
Different Ways to Consider NOI
In addition to ensuring that inputs and assumptions are correct, it is important to review NOI from multiple time periods. This offers a complete picture and better understanding of a property’s performance. A trailing 12 months, commonly referred to as a T-12 or TTM, is a summary of the income generated over a property’s previous year of operations. This metric provides insight into the property’s previous performance, which you can compare to actual NOI. This can validate certain assumptions that might not be reflected in historical numbers and show how the property is performing in real time.
Projected or stabilized NOI is utilized mostly for value-add or development opportunities. This is the NOI a property is expected to achieve once the business plan is executed. It is important to remember that projected NOI is based on a set of assumptions rather than proven income.
Adding value to an existing property has the potential to increase NOI. The chart below compares the in-place, or as-is, value of a value-add deal versus the stabilized value of an improved property. The decision to improve a value-add project depends on the defensibility of the assumptions used. Historical metrics can provide a good foundation when forecasting these future expectations, but they do not guarantee future success. So it is helpful to consider these time periods against one another.
Title: Change in NOI: Value-Add Deal
NOI’s Role in Determining Cap Rates
A property’s cap rate (which includes a property’s NOI and its estimated value or purchase price) provides a simple way to understand a property’s potential compared to its risk. While they vary by market, higher cap rates are generally associated with riskier investments but can be considered better opportunities.
Say you are evaluating two properties: Option A, valued at $5 million, and Option B, valued at $3 million. Keeping NOI constant at $200,000, Option A would have a cap rate of 4% while Option B’s would be 7%. Is Option B a better opportunity? Not necessarily. You must also consider the properties’ locations, ages and need for improvements. If Option B was an older building needing $1 million in improvements, Option A might be more favorable in the long run.
Is a higher cap rate driven by high NOI or lower property value? If a property appreciates but revenue lags the appreciation, the cap rate will be dragged down. And higher expenses result in a lower NOI—and thus a lower cap rate.
NOI drives returns and demonstrates how an investment firm is generating value in its assets. At Origin, the investment management team tests the acquisition team’s assumptions about future rents, expenditures, exit capitalization rates and many other inputs that drive value. The investment management team implements these model business plans after acquisition, constantly monitoring and adjusting the plan as the asset’s competitive landscape and the broader economy change. Being able to appropriately calculate NOI is crucial in the success of our projects.
