Net Operating Income Is The Measure of Value

September 18, 2020

How do you compare the value of multiple real estate investments across different industries and in different locations? While there are no metrics that give you the perfect comparison, net operating income is as close to perfect as you can get for most investment properties.

Defining NOI

Net operating income(NOI) is a metric that helps define the value of a real estate investment property by identifying the amount of revenue generated through regular operations.It’s equal to the operating income of a rental property minus the operating expenses to run that property.

NOI is very similar to EBIT (earnings before interest and taxes) and is essentially the real estate equivalent of this metric. Unlike EBIT, NOI is directly tied to property value. Increasing the NOI increases the property value while reducing it lowers the value.

Examples of Included Expenses

Here are some of the common expenses included in NOI calculations:

  • Utilities
  • General building maintenance
  • Insurance
  • Vacancy

Examples of Included Income

These are some of the most common income items lumped into NOI:

  • Rental income
  • Parking fees
  • On-premises services (laundry, vending machines, etc.)

Examples of Excluded Income & Expenses

Certain types of expenses and asset income are not included in the total NOI. Common examples include:

  • Capital injections (structural upgrades, property improvements, etc.)
  • Taxes
  • Investor payouts
  • Investor payouts

Why Use NOI to Measure Value?

NOI is a superior measure for determining how well you, as an investor, will be able to recuperate your investment. It’s useful in this context for three main reasons:

  1. NOI tells you about the cash flow of a property
    To purchase an investment property, you’ll need to take out a loan, seek investment, or some mix of both. Understanding the economic viability of a property helps you to both convince investors to join and apply for financing with a lender.

    Knowing the NOI of a property gives you a picture of the cashflow you can expect from a property once it’s under your ownership. With this in mind, investors will be able to complete their own risk assessment, and lenders can give you an appropriate amount of financing for the property. Suppose the NOI is actually an NOL (net operating loss). In that case, you, the investors, and the lenders will avoid a potentially unprofitable property.

  2. NOI shows you room for improvement
    Whether the property is currently running an NOI or NOL, there is often some potential for improvement once you make a purchase. If you have the numbers, you can analyze the areas that may offer you the wiggle room as the owner.

    Some properties are underutilized. By looking at the NOI and analyzing the property itself, you can better understand how you could recoup a potential investment and if it’s worth doing compared to other available properties.

  3. NOI allows you to calculate the cap rateA simple cap rate calculation is the property’s purchase price divided by the NOI (purchase price / NOI). Cap rates give you a reasonable estimation of how long you would take to recoup your investment at the existing level of returns and provide a ballpark for the property risk.

    The NOI of a property gives you a relatively complete picture of what’s going on with a property and what kind of cashflow you can expect from it in the future. This is an ideal starting point for determining an investment opportunity’s viability and for comparison against other properties.

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