GUEST POST: Carter Froelich, CPA www.thepropertyledger.com
Now that you have estimated the Effective Gross Income and your operating expenses, you can now estimate a property’s net operating income (“NOI”).
NOI is calculated as follows:
NOI represents the amount of funds the property is expected to produce after the payment of normal operating expenses. Here again, mortgage payments, capital improvements and depreciation are not part of the calculation of NOI.Why is NOI Important?We have spent the last 3 articles explaining the steps required to estimate a property’s NOI. Why is the estimation of a property’s NOI so important?NOI is one of the most important “numbers” in cash flow analysis in that:
1. Real estate investors are not purchasing an asset, they are purchasing an income stream and the NOI is the main component of that income stream. If you think that this is a crazy idea, when was the last time you purchased you a stock for the look of the stock certificate? The answer is “never”; you purchased the stock for the anticipated economic benefits which the company stock would provide you over time. The same is true for real estate investing.
2. NOI represents the return that the investor will receive on their investment if they purchase the property utilizing a 100% cash purchase. For instance, if a property’s NOI is $10,000 and the investor purchased the property for $100,000 cash, the investor’s cash-on-cash return (before taxes) is 10% ($10,000/$100,000).
3. NOI represents the maximum amount of funds available to service debt on the property should you desire to finance the property with a mortgage. For instance, the NOI of $10,000 could pay the mortgage on a $124,000 mortgage assuming a 30 year amortization period and a 7% interest rate or it could fund the a $150,000 note over a 15 year period at a 0% interest rate. Do you see how important this figure can be in the negotiation of the terms related to the purchase of real estate? We will be exploring this concept in more detail in later issues.
4. A traditional lending institution will utilize a property’s NOI to estimate the property’s debt service coverage ratio (“DSC”). The DSC ratio is the ratio between a property’s annual NOI and the property’s annual debt service. A DSC of 1 means that there is exactly enough NOI to support you annual debt service and not a penny more. A DSC of less than 1 indicates that the NOI is not sufficient to cover your debt service, while a DSC of more than 1 indicates that NOI is sufficient to cover your debt service with additional funds remaining.
5. NOI determines the value of the property in question when applying a capitalization rate (“Cap Rate”). A Cap Rate is defined as the anticipated rate of return produced by a real estate investment. The formula for a Cap Rate is:
Cap Rate = NOI/ Purchase Price
Thus if the NOI is $10,000 and the purchase price is $120,000, then the Cap Rate is 8.33% ($10,000/$120,000). In short, NOI is an objective measure of a property’s income stream, while the Cap Rate is a subjective measurement of how an investor’s capital must perform at a point in time. We will explore the concept of Cap Rates in detail in a future article.
6. NOI represents the starting point for the question, “How much money did I make this year?” This begins to get us into the discussion of taxable income which is calculated as follows:
NOI is one of the most important calculations a real estate investor can make as it is at the heart of so many other calculations which provide the investor with an indication of the performance of the investment. These calculations can then be compared to other real estate investments in order to select the investment which best meets the return requirements of the individual investor. In our next issue we will get into more details related to the calculation of taxable income.
Carter Froelich, CPA is the founder of The Property Ledger™ a web based real estate investment software. To get a free 30 day trial of The Property Ledger™ see our web site at www.thepropertyledger.com.
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