First, let’s start off with defining what is Net Operating Income (NOI)? This is a term you will see in property information documents for every real estate syndication. So, if it’s in every one, it must be important, right? It is. Net Operating Income is a calculation that shows the profitability of an income-generating real estate investment. NOI is determined by taking all revenue from the property (both rent and non-rent revenue) and subtracting all reasonably necessary operating expenses.
NOI is calculated as a before-tax figure which appears on a property’s income and cash flow statement. The calculation excludes principal and interest payments on loans, capital expenditures, depreciation, and amortization. The similar calculation in other industries, it is referred to as “EBIT,” which stands for “earnings before interest and taxes.”
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Now that we’ve defined what NOI is, why does it matter? There are lots of calculations and metrics that show up on a property information package or investment sheet. Why is NOI one of the metrics that matters most?
NOI is so important because it is one of the key metrics that is used to determine the value of a property. When NOI is divided by the capitalization rate (cap rate), the resulting number is the value of the property. NOI can also be used to determine the current cap rate of a property which can be compared to the prevailing cap rate for a given area. Knowing the current cap rate can tell you whether a building is undervalued or overvalued.
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When written as an equation, NOI is calculated as follows:
NOI / Cap Rate = Property Value
As an example with some sample numbers:
If the NOI for a property is $40,000 and the cap rate is 5%, what’s the value of the building?
$40,000/0.05 = $800,000
Thus, the NOI has a direct impact on determining the value of an apartment building. It also has a direct impact on increasing the value of an apartment building. Since the “NOI” term in in the numerator, an increase in the NOI means an increase in the value of the property.
If a sponsor team can increase the NOI of the example above by just 10%, meaning they add only $4,000 per year to the NOI by increasing the income, decreasing the expenses or a combination of both, the resulting value of the building rises by $80,000 ($4,000/0.05 = $80,000). That’s an $80,000 increase in value of the building with just a $4,000 increase in NOI for this example. Now you can see why NOI matters so much and how powerful of a metric this is. What if the increase in NOI was even more?
When you hear people talk about value-add apartments, NOI is the main metric the sponsor team is trying to increase on any value-add property. A value-add investment is a property where there is value that can be added to the property which will increase the NOI, and thus, the value of the building so the investment can be sold for a higher price than what it was purchased for.
In a separate article, I talk about some strategies on how to increase NOI for a property.
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Net operating income (NOI) is a commonly used figure to assess the profitability of a property. The calculation involves subtracting all operating expenses on the property from all the revenue generated from the property. The higher the revenues and the smaller the expenses, the more profitable a property is. This tells the owner if the income generated from owning and maintaining the property is worth the cost. It’s also the major metric that sponsors are trying to increase in order to increase the value of a property.
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If you’re interested in learning more about real estate, check out more of my education articles on my website at www.progresscapitalgroup.com/blog. Or, sign up for my newsletter at www.progresscapitalgroup.com/newsletter.If you’re interested in investing, you can schedule a call.