When purchasing any commercial real estate (CRE), calculating the NOI is important to determine what will be left over as “income” after expenses are taken. To determine NOI for most CRE and some net-lease properties, add the pre-tax revenue from rent received plus any other income (i.e., parking structures/fees, laundry facilities, etc.) then subtract expenses. Expenses include all costs of running and maintaining the building and property, as well as insurance premiums and legal fees, salaries and wages, utility payments, property taxes, common area maintenance (CAM) fees, vacancies, property reserves, and more.
Seems simple enough, right? It is once the expenses are calculated properly and there is an understanding of what’s NOT included in NOI. Let’s explore this further.
Understanding Net Operating Income (NOI) from CRE
When it comes to commercial real estate, the term “net operating income” has a slightly different meaning than NOI for business. It’s really 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 with cash, and income taxes or capital recovery had yet to be calculated.
GOI offers 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.
Additionally, to understand 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 concept of operating income. Think of it this way — commercial real state NOI is simply the income left over after operating expenses are deducted from revenue.
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, it’s necessary to maintain some portion of the property and ensure it continues 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 taxes are an operating expense, but the personal income tax liability the property generates is not. Mortgage interest is usually a tax-deductible expense, but it is not an operating expense since a mortgage is not used to operate the property.
Other operating expenses can include but are not limited to any wages paid in the operation of the property, all insurances, utilities, building maintenance, painting, plumbing, repairs, taxes, accounting and administration fees, common area maintenance (CAM), landscaping, snow removal, pest control, and more.
How to Calculate Cap Rate Formula & NNN Lease Property NOI
When looking at purchasing a triple net (NNN) lease property, for example, knowing the cap rate and calculating NOI is essential to assess its fair market value and to see what income you will earn. A higher cap rate typically equates to a larger ROI but may also indicate a bit more risk. A lower cap rate usually means less ROI, as well as potentially lower risk. (Cap rate is not the same as the cash-on-cash return, which is pre-tax cash flow divided by the total amount of cash invested).
If you are just beginning your property search, the simple calculation of NOI and cap rate gives you a measurement to assess properties and a solid idea of which ones best fit your objectives.
Since Triple net lease properties, especially absolute NNN lease investments, exclude all or most landlord responsibilities and expenses, Westwood Net Lease Advisors highly recommends NNNs. The tenant agrees to a long-term lease (10 to 20 years) that requires paying the “net” amount for three types of costs — net real estate taxes on the leased asset, net building insurance, and net common area maintenance, as well as all or most operating expenses and capital expenditures. This makes your NOI straightforward — it’s simply the rent received.
To Wrap it Up — NOI is just One Calculation of the Potential Income of CRE Investments
As you contemplate your CRE income goals, analyze the pros and cons of traditional commercial properties versus NNN lease properties. Then determine the net operating income and cap rates for each property you are interested in to get a feel for which ones would be right for your financial and lifestyle objectives. Keep in mind, this is only one calculation in the process. It’s also important to understand your risk tolerance as well as the property’s cash-on-cash return, ROI, and IRR.
Buyer’s Advisor No-Obligation Conversation
Not sure where to start? It is easy to consult with a trusted buyer’s advisor at Westwood Net Lease Advisors to learn more. At no cost to you and without obligation, we get to know you and learn your goals, use our extensive industry network to locate the perfect property selection for you, perform cap rate, NOI, and other important calculations, and represent you all the way through closing. Contact us today for a complimentary consultation and get the NNN investment that’s right for you. 314-997-5227.