Let’s Make Some (NOI)se For NOI
NOI. This powerhouse metric is a staple in CRE lending. And today, we’re breaking it down to the basics for you.
- What is it?
- How do you calculate it?
- Why does it matter?
These are some of the questions I often get asked on the job – and for good reason. NOI, which stands for Net Operating Income is a critical measure of whether an income generating property is going to be profitable or not. Which, if you’re reading this and are in the world of commercial real estate, you definitely care about.
NOI measures a property’s ability to produce income based on the income from its operation and is often confused with cash flow. But make no mistake, these two things are not the same. NOI is different than cash flow because cash flow includes debt service for the property (debt service = debt payments). Cash flow is the income generated after the debt is taken out. Basically, that means the cash that the owner makes off the property after all the expenses are factored out.
If you want to understand what the NOI of a property you’re considering is, you’ll need to know how to calculate it:
First, we need to determine the Total Revenue of the property. So, for example, let’s say you have an investment property that makes $15,000 per month in rental income, after you subtract out any of the vacancies and concessions (more on that in a moment), you’ll multiply that by 12 – which puts you at $180,000 per year (your Total Revenue).
Next, you’ll need to subtract out any of the operating expenses. What falls into that category? Things like repair fees, maintenance fees, property management fees, insurance, etc. Now, I know what you’re probably thinking: where’s the mortgage payment in that list? Surely that would be included in your list of expenses for the property, right? Not exactly.
Technically, we don’t consider your mortgage as an operating expense, but rather, what’s known as a ‘finance expense’. Here’s why that matters: finance expenses are incurred by the owner/investor of the property rather than the property itself. (This is important to note because NOI is only intended to capture the income produced by that property. Finance expenses, on the other hand, can vary from borrower to borrower depending on how much they are financing their loan for and the structure of that specific loan. In other words: It’s not relevant in this case.) So, for this example, let’s say you have $50,000 of operating expenses each year. You’ll subtract that from your $180,000 which leaves you with $130,000. Your NOI.
The math is simple enough, but the result matters. A lot. Not only is NOI a really simple and reliable way to get at the value and potential of an income producing property – it’s also used to calculate lots of other critical CRE metrics as well. For example, you’ll use NOI to determine things like:
- DSCR (NOI / Annual Mortgage Debt)
- Cap Rate (NOI / Current Market Value)
- Property Value (NOI / Cap Rate)
A Brief Interlude on Vacancies and Concessions:
Let’s get back to vacancies and concessions for a moment. Vacancies take into account the % of rental space at a property that is not currently leased, or is currently vacant. We remove vacancies out of the calculation because we currently aren’t collecting any rental revenue from that space. Concessions are typically given to someone as an incentive to sign a lease. Typically, this would be in form of free rent for a new tenant. For example, many places will give you one month of free rent if you ‘sign today’. In cases like these, you’ll want to make sure that the one month of free rent is not included in total revenue because it was not technically collected.
…Aaaaand that’s a wrap on NOI! Hopefully this gives you a better understanding of how it’s used and its importance to CRE lending. Still have questions? Drop me a note: firstname.lastname@example.org.
Until next time!