What is NOI on a NNN lease?
In commercial real estate, understanding Net Operating Income (NOI) is critical. It is hard to completely comprehend investment real estate deals without a clear understanding of net operating income, sometimes known as “NOI.”
What is NOI?
The most extensively used performance statistic in commercial real estate is net operating income (NOI). What exactly is NOI in real estate? The net operating income for a property is defined as the entire operating income less the total operating costs for the property.
The net operating income is helpful because it indicates the capacity of a property to produce money without taking into account its capital structure. Because various owners will have varying capital structures and financing costs, the NOI allows for the assessment of property performance before any of these owner-specific elements are included.
Because operational expenses are measured “above the line,” while capital expenditures and leasing costs are calculated “below the line,” net operating income is commonly referred to as “the line.”
Net operating income (NOI) is the money earned by a property, less all operating expenditures. The following is the fundamental net operating income formula:
Potential Gross Income – Vacancy and Credit Loss = Effective Gross Income
Effective Gross Income – Operating Expenses = Net Operating Income
The calculation of net operating income might vary depending on the property type or the parties involved.
A multifamily property, for example, may include property-specific line items such as lease loss, while an office building will have line items for tenant reimbursements.
In any case, the net operating income formula is the same at a high level and measures operating income less operating expenditures.
How should you calculate NOI?
After you separate out each of the various components, calculating net operating income is quite simple. Potential rental revenue, vacancy and credit losses, other income, and running expenditures are the key components of net operating income.
Potential Rental Income: Potential Rental Income is the total of all rentals due under each lease, provided the property is fully occupied.
If the property is not fully occupied, a market-based rent is calculated using lease rates and conditions from similar properties.
Vacancy and Credit Losses: These are revenue losses caused by renters leaving the property and/or tenants defaulting (not paying) their lease payments. The vacancy factor may be estimated for the purposes of computing NOI based on current lease expirations as well as market-driven data utilizing similar property vacancies.
Effective Gross Income: In the net operating income calculation above, effective gross revenue (EGI) is simply prospective rental income minus vacancy and credit losses. EGI is the amount of rental income that a property owner might reasonably anticipate getting.
Operating Expenses: All cash expenditures necessary to run the property and command market rentals are included in operating expenses. Real estate and personal property taxes, property insurance, management fees (on or off-site), repairs and maintenance, utilities, and other miscellaneous charges are common commercial real estate running expenses (accounting, legal, etc.).
Net operating income: It is the end outcome of effective gross income less operating costs, as illustrated in the net operating income calculation above.
The owner of income-producing real estate employs NOI to get a clear picture of the cash flows created by the property. This is due to the difficulty of manipulating NOI. You can only increase NOI by increasing rental or fee revenue, decreasing vacancies, or minimizing operational expenditures. NOI is unaffected by financing or income tax issues, making it an excellent metric for analyzing how effectively a property is handled.
For example, the operational margin, which is calculated by dividing prospective rental revenue by NOI, may be readily compared across identical properties. It is critical to compare the NOI components of a property to those of competing properties in the same neighborhood. It may also assist company owners in comparing several properties that they own.
Another major use of NOI is trend analysis, which examines how a property’s NOI has evolved over time. A declining NOI should serve as a warning sign that corrective work is needed or that the property may be a potential candidate for sale.
If you own a real estate company and are seeking to purchase additional income-producing properties, you would often thoroughly check the financials of the properties, especially the income statements, for factors such as NOI. You now have a method of appraising the property and forming an offer.
NOI is also employed in other significant equations in the real estate industry, such as:
Capitalization rate: Also known as “cap rate,” it is equal to NOI divided by the value of the property. This is the rate of return on an all-cash purchase of a property. For example, if you spend $1 million for a property with a $100,000 NOI, the cap rate is 10%. The higher the cap rate, the greater the return on investment, but the greater the possible danger. The cap rate is also employed in more complicated calculations to assess the cost of debt and the cost of equity capital when purchasing an income-producing property.
Property value: It may be calculated using the cap rate equation, which is NOI divided by the cap rate. This is useful for estimating the fair worth of a property based on the NOI and cap rates of comparable properties in the same neighborhood.
Debt service coverage ratio (DSCR): DSCR is NOI divided by yearly debt service, which is the amount of principal and interest required to repay a loan each year. It indicates if you have enough revenue cash flow to pay your debt servicing commitments. The greater the DSCR, the greater the financial cushion available as a safety buffer.
Naturally, lenders favor homes with high NOIs because they take this as evidence of a low likelihood of loan default. From the lender’s perspective, NOI is significant not just in establishing the DSCR to help assess a borrower’s creditworthiness but also in determining the maximum loan amount through the loan-to-value (LTV) calculation.