The use of capitalization rates to estimate the value of an income- producing property is essential to the financial analysis of the property. However, the value of an investment property is ultimately determined by the relationship of three variables:
- capitalization rate,
- present value and
- net operating income (NOI).
In this entry, we take an in-depth look at NOI and explain why understanding it is essential to understanding the value of commercial real estate property.
UNDERSTANDING NET OPERATING INCOME
Net operating income is the income left over after operating expenses are deducted from revenue. However, concerning investment real estate, the term “net operating income” is a minor variation on this term. It is a property’s gross operating income (GOI) less operating expenses. For example, you could think of NOI as the money a property would return in a given year if it were purchased in cash, and income taxes or capital recovery had yet to be calculated.
GOI is an allowance for vacancy and credit loss subtracted from a property’s gross scheduled income (GSI), which is the property’s annual income if all space is rented and all rent is collected. In addition understanding the forms of income associated with an investment property, investors must also be clear on what counts toward expenses. For many investors, the concept of operating expenses presents more confusion than the concepts for operating income.
UNDERSTANDING OPERATING EXPENSES
Many people consider an operating expense to be any expense associated with owning a property. However, this strict definition of operating expenses doesn’t hold true in all cases.
To be considered a real estate operating expense, an expense must be necessary to maintain a piece of a property and insure its ability to continue to produce INCOME. Therefore, loan payments, depreciation, and capital expenditures are not considered operating expenses.
In contrast, utilities and property management fees are operating expenses. Repairs and maintenance are also operating expenses, but improvements and additions aren’t — they are capital expenditures. Property tax is an operating expense, but personal income-tax liability the property generates is not. Mortgage interest may be a deductible expense, but it is not an operating expense. A mortgage may afford one the property, but it is not used to operate it.
Subtracting operating expenses from GOI gives you NOI. With a triple net lease property, calculating NOI is essential to assessing its fair market value. The market value of the property is an attribute of its “income stream“, which is an attribute of NOI. A real estate investment is not a collection of bricks and building fixtures. Instead, it is an income stream that the operation of a property generates independent of external factors such as financing and income taxes.