The most important metric to understand when evaluating income-producing real estate is Net Operating Income (NOI). NOI, along with the prevailing capitalization rate (cap rate) for your investment type, grade, and location, controls the value of your investment. And unlike the cap rate, you have a large degree of control over NOI. So it’s critical that you understand all the components of NOI and how it works.
What is Net Operating Income?
Net Operating Income (NOI) is the net annual income of the property, not including financing (debt) costs, reserves, or non-asset related fees. When comparing two properties, assuming cap rates are the same, the property with a higher NOI will be worth more.
NOI Formula: Net Operating Income = Gross Operating Income (GOI) from the asset minus Operating Expenses
NOI is the total annual revenue (GOI) a property generates from all sources minus the total annual operating expenses. For most apartment assets, a good rule of thumb is that GOI will be approximately twice NOI depending on the real estate tax rates in that location.
- Real Estate Property Revenue: Property revenue includes all types of income. While rental income is typically 90% or more of the total revenue, other sources can also help, such as pet fees, dedicated parking, amenity fees, washer/dryer leases, and more. The combined total of rental income plus other income and utility reimbursements is Gross Operating Income.
- Operating Expenses: Operating expenses include real estate taxes, payroll for onsite staff, insurance, property management fees, maintenance and repairs, utilities, and other costs associated with running the property. As noted above, debt service, capital improvements, reserves, etc., are not included.
How Does NOI Impact Real Estate Valuation
Commercial real estate is an illiquid and inefficient market. For some investors, a certain asset price will be cheap. For others, it could be quite expensive. A lot of the difference in pricing opinion is a function of the long-term view of the safety/profit potential of the asset compared to that investor’s business plan and holding period. That said, you need a baseline understanding of value.
Professionals use an extensive multipoint assessment during their due diligence. For example, at 37th Parallel, we look at an array of various data points, employ local boots-on-the-ground knowledge, and underwrite properties across several potential market outcomes before making an offer.
If you’re a passive investor, you can leverage the research and expertise of professionals. But it would be best if you still understood net operating income (NOI).
Net Operating Income and Valuation
Per-door pricing and comparative-sales pricing are other ways to value multifamily real estate, but the most useful and generally the most well-regarded valuation tool is Net Operating Income (NOI) divided by the capitalization rate (cap rate). This is an income-based approach to valuing income-based real estate.
The formula for calculating value is:
NAV = NOI / Cap Rate
As we covered earlier, NOI is all the property’s revenue minus all operating expenses.
The Capitalization Rate (Cap Rate) is a percentage and represents the rate of return one would expect to receive on a property if they owned it free and clear of financing.
Cap rates vary by market, asset class, grade, and condition. If the market cap rate is 5%, one would expect a 5% annual yield (income) from a property if they owned it outright.
An Example for Calculating Value Using NOI
The best way to understand valuation based on NOI is to look at an example. Let’s assume that a property brings in $700,000 yearly in net operating income and the market Cap Rate is 5.0%.
$700,000 divided by 5.0% is $14,000,000
Minor Improvements in NOI Can Pay Off Handsomely
The leverage provided by this valuation model is significant. Even the smallest improvements to NOI can make a significant difference. Increasing retention reduces vacancy and turn costs improving both top-line revenue and reducing expenses. Reducing operating costs, or even reducing the growth in operating costs below market, can add material value to the bottom line. Growing revenue by implementing yield management systems can increase annual revenue. The list goes on. Ultimately, NOI optimization is an incredibly valuable skill and experience set that pays dividends.
Let’s look at a few NOI optimization examples.
Over the last seventy years, national rental occupancy rates have been remarkably stable, remaining in the 90% to 95% range. That is good news for those looking to derive retirement real estate income from their multifamily investments.
And while 90% occupancy can be profitable, most markets are even higher than that today, in the 93% to 96% range. Every point of occupancy matters.
For example, look at a 100-unit property that brings in $1,000 per unit per month net after all operating expenses (likely a $2,000/month asset). At 95% occupancy, that property makes $95,000 in monthly net income. At 90% occupancy, it brings in $90,000.
Over one year (12 months), the net operating income is as follows:
95% Occupancy = $95,000 x 12 months = $1,140,000 (NOI)
90% Occupancy = $90,000 x 12 months = $1,080,000 (NOI)
The net income difference between the two occupancy scenarios (90% vs. 95%) is $60,000 annually.
Now, let’s add the capitalization rate to the annual NOI difference to see the difference in value.
We will use the formula Value = NOI / Cap Rate. And we will assume the Cap Rate in this hypothetical example is 5%.
90% Occupancy: Value = $1,080,000 / 5.0% = $21,600,000
95% Occupancy: Value = $1,140,000 / 5.0% = $22,800,000
It’s a $1,200,000 value difference with 5 more units rented during the year.
Let’s continue with our hypothetical 100-unit property that brings in $1,000 in net operating income per unit. But this time, let’s look at what a $ 20-a-month (1% for a $2,000 per month unit) rent increase does to the value of a 100% occupied property.
Before Rent Increase = $1,000 a month x 100 units x 12 months = $1,200,000 (NOI)
After Rent Increase = $1,020 a month x 100 units x 12 months = $1,224,000 (NOI)
The difference is $24,000 in increased net income per year.
Next, we apply the valuation formula:
Before Rent Increase = $1,200,000 (NOI) / 5.0% Cap Rate = $24,000,000 (Value)
After Rent Increase = $1,224,000 (NOI) / 5.0% Cap Rate = $24,480,000 (Value)
The difference is $480,000 in increased value.
In this example, a one percent ($20/month on a $2,000/month lease) rental increase resulted in nearly a half million dollars in increased value.
Let’s continue with the above example and suppose that in addition to a $20 rent increase, the management reduced expenses by $20 a unit. It could have been from a renegotiated contract, insurance reductions, or a combination of other expense management protocols.
In this example, we are looking at a net operating income of $40 monthly per unit from both rent increases and expense reductions.
Before: $1,200,000 (NOI) / 5.0% Cap Rate = $24,000,000 (Value)
After: $1,248,000 (NOI) / 5.0% Cap Rate = $24,960,000 (Value)
The difference is $960,000 in value.
In this example, a one percent ($20) increase in rents and a $20 per unit decrease in expenses result in nearly one million dollars in increased property value.
As you can see, diligent operations and focusing on asset management/asset optimization matters – even for the little things.
37th Parallel is a Trusted Partner for Real Estate Investing
37th Parallel Properties is a multifamily-focused private real estate acquisitions and asset management company.
We’ve been in business since 2008 and have maintained a 100% profitable track record for our investors across more than a billion dollars in transaction volume.
We’ve made our investors money in good times and bad, in bull and bear markets, and across multiple recessions. That’s because we know what works and put our investors first. And we write articles like this one because knowing how these investments work is critical to our joint success.
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