I recently put a group of investors together, and we bought a strip center. The opportunity of this property is to increase the rents from an average of about $12/sf to the market rate of about $17/sf over a period of approximately 3 years. If I can achieve this while maintaining the operating expenses of the property, then I can significantly increase the Net Operating Income (NOI) of the property and ultimately the value
Simply defined, the NOI tells you how profitable a piece of property is. You calculate all the income the property generates and then subtract all of its operating expenses. Pretty simple, right? But there are some nuances.
How to Calculate NOI
The formula for calculating NOI is pretty simple, but takes some explaination.
NOI = Gross Income – Operating Expenses
The first step is to figure out the Gross Income of a property over the course of a year. When I say gross income, I mean everything the property makes. When I owned apartments, many of them had coin laundry facilities. Not only did the apartment complex collect rent from the apartments, but the property made money from the laundry facility as well. An office building might make additional income from paid parking. A retail strip center might earn additional income from the tenants reimbursing the owner for proportionate shares of property taxes, insurance, and Common Area Maintenance (CAM).
To calculate Gross Income, then, use this formula:
Gross Income = Potential Rent Income – Vacancy/Credit Loss + Additional Income
Potential Rent Income (PRI) is the amount of money a property would make if it were fully leased, 100% of the time, at market rates. It would be fantastic if a property were 100% leased 100% of the time, but that isn’t reality. A shrewd CRE investor will look at the market and see what a realistic vacancy rate should be for the property. Then finally, add in the additional income (laundry, parking, etc) that might apply to the property.
Once you have the Gross Income figured out, you then calculate the Operating Expenses. There is no formula here. You simply add them all up. The tricky part is only including the operating expenses at the property level – not the investor level. In other words, you only include the expenses that are property specific. Here are some examples of operating expenses:
- Property Taxes
- Property Insurance
- Repairs and Maintenance
- Contract Labor
- Property Management
- Professional Fees
There are a number of expenses that aren’t included in the NOI calculation because they are specific to the investor. These expenses are said to be “below the line” – meaning that these expenses come below the NOI line. These below the line expenses include debt service, depreciation, income taxes, capital expenditures, and tenant improvement expense. All of these expenses are investor-specific and you do not include them in the NOI calculation.
Because the NOI tells us how profitable a piece of property is on its own. The benefit is that this allows us to compare it to other investment properties on its own merits. It allows us to more closely compare apples to apples.
For years, I saw my dad review the monthly Profit and Loss (P&L’s) statements on our properties. I do the same thing now. It is key to note that the Net Income line at the bottom of a P&L is not the same as the NOI of a property. On a P&L, depreciation and debt interest expense are included in expenses. So don’t make the mistake of looking at a P&L and thinking you are seeing the NOI of a property. You would need to add back the interest expense and depreciation to get the NOI.
So why is this important?
The NOI is important because it is how commercial real estate investment property is valued. Once you have the NOI, you divide it by the appropriate Cap Rate to get the value. For example, if the NOI of a property is $50,000 and you buy it at a 7% Cap Rate, you would pay almost $715,000. If you could increase the property’s NOI over time to $65,000 and sell at the same 7% Cap Rate, you would sell for almost $930,000.