When evaluating a commercial real estate investment, there are a handful of metrics that are absolutely critical to understanding the current and/or future return potential of the property. One of, if not the, most important metric is net operating income (NOI). Net operating income is the income generated by a property after subtracting operating expenses.
Net Operating Income Formula
The net operating income formula is simple enough:
net operating income = gross operating income – operating expenses
Where the NOI calculation is a bit more difficult is determining exactly what falls into the “Gross Operating Income” and “Total Operating Expense” categories. The task is made more complicated by the fact that it can be slightly different from one property to another. As such it is helpful to look at the details of each category.
Gross Operating Income
Gross Operating Income is the sum of all property income less vacancy. It can be useful to view the components in a table (NOTE: The exact terminology may vary from one deal to another)
Once Gross Operating Income is calculated, operating expenses are deducted. Again, the exact expenses required to operate a property may vary from one to another, but they generally fall into the below categories:
Subtracting the two components from each other, gross operating income – total operating expenses, results in a property’s net operating incomenet operating income.
¹There is some disagreement about whether Reserves should be included above or below the NOI line. Methodology may vary from one deal to another
Why Net Operating Income Matters
There are two reasons why net operating income is critically important to understanding the current and/or potential return on a commercial real estate investment:
- It is used as the basis for Commercial Real Estate valuation
- It can be used to “force” a property to appreciate
Unlike residential real estate, which is valued on “comparable sales”, Commercial Real Estate is valued on the amount of net operating income that a property produces. The more it produces, the more valuable the property and vice versa. A valuation estimate is derived by applying a cap rate to net operating income. For example, if a property produces $100,000 in net operating income and the prevailing market cap rate is 6%, a rough valuation estimate would be ($100,000/6%) $1.6MM. If a comparable property produces $90,000 in net operating income and the same cap rate is applied, it has an approximate value ($90,000/6%) $150,000. This difference in value highlights the second reason why net operating income is critically important, the property owner has direct operational control over it.
If it is known that net operating income is calculated as Gross Operating Income – Total Operating Expenses, then the owner of the property can actively pursue a variety of strategies designed to increase it. In general these strategies are designed to increase income, decrease expenses, or both. For example, we prefer to manage our own properties. So, when we purchase a property that is currently managed by a third party vendor, we are able to bring that function in-house, which immediately reduces expenses and increases net operating income. At a 7% cap rate, every $1 added to net operating income results in $14.28 of added property value. At scale, a successful value-add program can be a major contributor to a profitable investment exit.
Interested In Learning More
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage decades of expertise and available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
When evaluating acquisitions on behalf of our investors, we carefully evaluate a property’s existing and potential net operating income as part of our pre-purchase due diligence program. Through this evaluation, we develop a value-add business plan for the property and begin to execute it immediately after the transaction closes.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.
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