Real estate investments are a hotbed of profits and financial returns. However before committing huge amounts of money to the development, purchase or renting of commercial properties. investors must carefully evaluate profitability and risks associated with earning that profit. Creditors and investors in real estate use several metrics to calculate a commercial property’s potential returns. Net operating income (NOI) is one of the most important profitable formulas, used to calculate the anticipated revenue flow and the underlying risk of a commercial real estate investment. Thus, net operating income serves as a valuable standard for identifying potential lucrative deals or evaluating the performance of existing investments.
In this article, we discuss the importance of net operating income in a commercial real estate investment.
What is net operating income (NOI) in commercial real estate?
Annual noi or Net operating income (NOI) illustrates the annual revenue generated from a property after subtracting all the annual operating expenses. The formula for NOI is:
Net operating income = Real estate gross revenue – Operating expenses
While underwriting a commercial real estate investment, investors must calculate the NOI to identify the profitability of an income-generating asset. In other words, NOI helps real estate professionals to estimate the precise value of their properties accurately.
Which expenses are included in net operating income (NOI)?
What constitutes gross real estate revenue in NOI?
A commercial real estate asset generates various additional revenue besides rental income. These collectively form the gross revenue from the real estate asset. Gross real estate revenue includes:
- Gross rental income
- Late fees
- Retail sales in a storage facility from items such boxes and moving supplies
- Income from on-site laundry facilities
- Parking fees
- Fitness centre fees
- Application fees
- Income from on-site vending machines
- Revenue generated from signage/billboards
- Pet deposits or monthly pet fees
- Service charges
Investors should add up rental income with these revenue-generating items on the property to get the gross revenue on a property. This is because all of these ancillary activities together contribute to the cash flow of the property. After they find out the gross revenue, the real estate underwriters would determine the ‘effective rental income’. If vacancy, credit losses and concessions are deducted from the gross revenue, they can get the effective rental income. To attract potential or existing renters to sign leases or renew them, effective rental income becomes essential as it is the actual income the renters will collect.
What constitutes operating expenditure in NOI?
The next step is to find out the operating expenses on the property. The operating expenses of a property refer to the day-to-day cost of running and maintaining an income-generating property. Some of the examples of operating expenses include:
- Property management fees are a small percentage of the rent collected from a rental property. Passive investors pay property management fees to property managers who undertake day-to-day property management tasks on the behalf of the investors.
- Investors also have to pay general maintenance fees. This includes any expense related to property maintenance and repairs including groundskeeping, plumbing, electrical work and so on.
- Utility fees including water, electricity, phone, water, gas, internet and others that the owner pays will be deducted from the income generated from the property.
- In some cases, the owner has to pay an attorney for drafting a lease or litigation fees for the ownership of the property. In addition to this, bookkeeping and accounting charges are also legal fees that account for an operating expense.
- Property taxes that the owner must pay to the local governing body are also operating expense. Property taxes depend on the location, size and value of the property.
- Rental property insurance that protects property from loss of income, any weather-related damage or otherwise is also a deductible expense.
- Marketing or advertising fees for the property are an operating expense.
- Lawn care and pest control expenses
- Expenditure for administrative and office supplies
- Unit vacancies that affect the average rate of rents in their vacancy periods also count in this category.
Which expenses are not included in net operating income (NOI)?
These core expenses that help in maintaining a property become operating expenses. However, there are several other expenses that are not included in this category. They are:
- NOI excludes financing costs and debt services that are specific to the owner. These include mortgage payments or payments to private lenders, partner or capital reserves.
- Property depreciation that does not affect the actual cash flow is not part of NOI.
- In the calculation of NOI, Income taxes that are specific to the owner does not count.
- Tenant improvements that a particular tenant undertakes to suit their personal requirements are not part of NOI.
- Capital expenditures are expenses that are dedicated to major renovations and replacements like roofs, floors, HVAC replacement etc. There are Reserve funds that are set aside in case the requirement for such major replacements arise. As these expenditures are unforeseen and occur irregularly, NOI does not include capital expenditures.
- Leasing commissions that real estate agents and brokers charge for leasing the space are also not a part of the NOI calculations.
It is ideal to have an NOI that is positive which occurs when the gross revenue from a property exceeds the gross operating expenditure.
How does NOI help in calculating commercial real estate investments?
NOI estimates whether a potential commercial real estate investment is profitable or not. It also helps in determining various details of a property ranging from its value to how it compares to its debt. For this purpose, investors should consider deriving other equations that are incomplete without the NOI value of the property. These calculations include:
- Capitalization rate (Cap Rate)
The capitalization rate is equal to NOI divided by the property’s current market value. This is the potential rate of return of a property in the first year of its acquisition. Cap rates are highly useful to determine the prices for buying or selling properties. Typically, higher cap rates provide larger returns on investment. Lower cap rates increase the cost of the property and decrease returns for the investors. Hence, investors look for higher cap rates whereas sellers want them lower. Capitalization rates also find the cost of debt and equity capital while investing in an income-generating property.
- Debt service coverage ratio (DSCR)
To calculate DSCR, one must divide NOI by annual debt service. The amount of principal and interest one must pay each year to repay a loan is the annual debt service. This metric enables lenders to determine whether or not a borrower can repay a loan. Therefore, lenders prefer higher DSCRs. This is because more DSCRs indicate the property is producing a cash flow of income to pay down the mortgage. During volatile market conditions, lenders require higher DSCRs to sanction a loan.
- Cash on cash returns
Cash on cash return of a property is the ratio between the annual net cash flow and the initial cash investment or the purchase price of a property. This helps sponsors and investors to determine the present and the future-income potential of a property before an investment.
How important is net operating income (noi) in commercial real estate?
- The obvious advantage of NOI investment in commercial real estate is that it helps investors to determine the initial value of a property. Cap rates give investors an idea of the potential rate of returns of a property.
- Furthermore, the current revenue scenario and occupancy rates of a specific property help investors to gauge the potential gross rental income returns.
- NOI also determines the debt service coverage ratio (DSCR). It is beneficial for lenders as they can determine if a borrower has sufficient income to meet the debt service obligations.
- Cash on cash returns also help investors to estimate the overall yield or returns, a specific property generates.
How to maximize NOI in a commercial real estate investment?
Net operating income is largely property-specific. This is because every investor’s management and operation style vary from one another. An underperforming property may see a huge difference between the projected NOI and what the property actually earns. Hence, it is ideal to conduct an extensive market analysis of a specific property’s potential costs, expenses and income.
In order to achieve maximum NOI for their commercial real estate investment, an investor should:
- Commercial real estate investors can maximize their NOI net operating income by boosting their rental income. Various property owners tend to defer increasing their rents in order to retain their tenants. A comprehensive market survey, rent comparison, and inputs from seasoned real estate professionals might help to determine the accurate market rent. To decrease vacancy rates, owners should consider stepping up their marketing game and speed up move-in timelines.
- Owners must keep an eye on how their rental rates are performing against their actual costs and against other properties.
- Value-adding to the properties by renovating them with premium amenities are likely to attract quality tenants. This also translates into higher rents.
- Investors should also focus on providing additional facilities to the properties. Such alternative sources of revenue include paid parking, charging for pet services, storage spaces, daycares, fitness centres etc.
- Another significant solution to improve NOI is to minimize operating expenses. Owners should eliminate unnecessary expenditure on electricity, water usage, expensive insurance costs and high maintenance fees.
- Reducing rent concessions, tenant turnovers times and costs can also cover the low NOI rates.
Never underestimate the power of NOI
It is needless to say that NOI, net operating income is a crucial part of a commercial real estate investment. It not only evaluates the stabilisation of an existing property but also projects the profitability or risk factor of a potential investment. Investors experiencing negative NOI must employ several techniques that can make property management more efficient. Furthermore, embracing alternative sources of revenue generation and minimizing operating expenditure will also increase the gross revenue significantly.