The Net Operating Income (NOI) is one of the most important figures when analyzing the profitability of commercial real estate investment. It is calculated the difference between the property’s rental income and its operating expenses,. It is used to calculate the before-tax-cash flow by deducting the mortgage payment, which depends on the term of the loan and the mortgage rate. The major reason for the importance of the NOI is that one of the major methods used by industry professionals to determine the value of commercial real estate is the income capitalization approach, according to which the value of an income producing property is equal to: Value = Net Operating Income / Market Cap Rate Thus, if the Net Operating Income of a commercial property and the market capitalization rate that can be reasonably applied to it (given its characteristics) is known, it can allow for a quick and rough estimate of the market value of the property.
The NOI is also necessary for the calculation of Debt Coverage Ratio or DCR, which provides to mortgage lenders and investors a measure of a property’s income-earning ability to cover both it’s operating expenses and mortgage payments. The Net Operating Income is also a critical part of the Income Statement, Cash Flow Statement and return calculations for a commercial property. In particular, it is important in estimating the Net Income Multiplier, and the internal rate of return (IRR) of a commercial real estate investment.
NET OPERATING INCOME FORMULA
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: Property Management Fees 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 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 a commercial 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 or commercial space. 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 vacant 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 assess whether the market is becoming softer or stronger in order to better estimate the rental rates at which vacant units will be rented. These forecasts will then provide the basis for producing projections of the net operating income over the holding period of a commercial real estate investment.
Shopping Centre Net Operating Income
According to Don Paul in “Shopping Centre 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 centre. 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