Net Operating Income (NOI) – King of the Metrics

by Landon M. Scott

Net Operating Income is the single most important measurement in commercial real estate. Whether you have a single family residence that you rent out, or a ten story high rise, Net Operating Income (NOI) is the amount of income that goes to the owner of the property after expenses are deducted from income, but before debt service or income taxes are considered.

The income that goes into the calculation is all income from the property except for the interest payments for money placed in reserve. The terms associated with income are Gross Potential Rent (GPR) and Effective Gross Rent (EGR), sometimes referred to as Effective Gross Income (EGI). Effective Gross Rent (EGR) is simply Gross Potential Rent (GPR) less vacancy.

The expenses that reduce the EGR of the property are all expenses that can be categorized as an Operating Expense (Op Ex) and deductible for the purpose of that year’s income tax. For example, the IRS won’t let you deduct the price of a new roof in the year it was replaced – you have to amortize it over a period of time (for commercial real estate anyways, depreciation isn’t allowed on residential properties where the owner occupies the property). Therefore, it is not an Operating Expense (Op Ex), but rather a Capital Expense (Cap Ex). I’ll write another blog in the near future about Capital Expenses and how they are treated. The simple rule is this: if the benefits of the cost incurred are a year or less, it’s an Operating Expense; if the benefits of the cost incurred are greater than a year, it’s a Capital Expense (Cap Ex).

So, the Net Operating Income is the Effective Gross Income less the Operating Expenses (Op Ex). It will look something like this:

Some other terms you will find useful are: Loss to Lease, the amount the contract rent is less than what you could get at market rents; Bad Debt, the amount that you don’t receive from the tenant that you were entitled to per the lease; Collections, the amount of Bad Debt that you collected on at some point that same year/month; Concessions, the amount of rent you gave freely to the tenant, usually as part of a promotion; and Replacement Reserves, the amount that is placed in reserve as part of prudent management or required by the lender for a rainy day – is sometimes not calculated in NOI, particularly when the property’s operations are presented in marketing material by seller’s brokers.

The Net Operating Income is so important because it shows the performance of the property apart from leverage/debt, taxes, and partnership splits. Think about it as the dividend on a stock; it is the Return On Asset (ROA) in dollar terms and it will be the same regardless of who your lender or accountant is – it is the most unbiased of all the measurements.

Which is why it is used, as a ratio of the purchase price/value, to express the Return On the Asset (ROA) in percentage terms; the NOI divided by the Purchase Price gives you a one year Return On the Asset (ROA), otherwise known as the CAP, or Capitalization Rate.

If your stock portfolio is returning a return of 10% and you purchased a property at a 7% CAP Rate, your stock portfolio is outperforming your property (in risk UN-adjusted terms, so not exactly apples to apples). But if your return on a commercial Real Estate Investment Trust (REIT) portfolio is returning 10% and you purchased an income property  for a 7% CAP Rate, your REIT portfolio is doing better (in risk ADJUSTED terms) than your purchase, for that year at least, because the risk profile is similar. But that is why NOI and CAP Rate are some important, because you can look at NOI, and therefore the CAP Rate, in relation to your other investments. NOI and CAP rates don’t live in a world of their own, they compete for your dollars alongside other investments.

What about measuring the performance of your property for the life of the investment, a more appropriate and realistic evaluation of your income property investment? See Internal Rate of Return (IRR) in my previous post.

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