If you’ve ever bought or sold a primary residence before I’m sure you’re quite familiar with the process of having your realtor pull listings of other similar properties in your area to serve as “Comps” for determining the market value of the residence you are buying or selling. Comparative analysis (“comps”) serves as the standard way to price and track market value of residential housing (1-4 unit size properties). Obviously, there are things that can push the market value of your place higher or lower than what these “comps” indicate, but that is essentially a benchmark for what is happening in the market for similar properties within a given radius of your property.
When evaluating commercial residential property that method of valuation is not applicable. Sure, you will likely look at some comps of similar properties, but the true determination of the property value will come down to NOI, Net Operating Income. When banks are lending on commercial property they will be less concerned with what the landlord across the street sold a similar property for 6 months ago; instead, they will want to know how much income can this property generate and how much cushion is there in that income to support not only the regular, anticipated expenses of the property but also the amount of margin there is in that income to support its own debt service (DSCR). For banks and commercial property, it’s all about how profitable the business is currently with perhaps some leeway for how profitable the business/rental can be if you can sell the lender on your story and plan for adding value (and subsequently income) to the balance sheet.
So how does one determine NOI you might ask? If you are going to be evaluating commercial size residential property, you will need to be very familiar with thinking in terms of NOI, so let’s take a look. Every month you receive a net amount of rental income as a result of tenants paying rent minus any rent attributable to vacancy plus any additional revenue streams from things like garage rentals or laundry facilities. From that net rental income you pay out the typical expenses like management expense, repairs and maintenance, insurance, lawn care, utilities, etc. The remaining amount left after subtracting your expenses from net income is the net operating income, NOI. Note that this does NOT factor in any debt service (loan payment) you have on the property, it is simply the net of income minus expenses. The NOI minus any loan payment is termed CASH FLOW. To illustrate an example in spreadsheet form would look something like this:
gross rental income = $ 10,000.00
vacancy = $ 500.00
net rental income = $ 9,500.00
TOTAL INCOME = $ 9,500.00
operating expenses = $ 4,000.00
property tax = $ 833.33
insurance = $ 208.33
TOTAL EXPENSES = $ 5,041.67
NOI = $ 4,458.33
debt service = $ 2,700.00
cash flow = $ 1,758.33
The NOI will be what you and the bank will be utilizing to value a commercial property and subsequently determine your eligible loan amount in the case of obtaining financing. NOI, in conjunction with the prevailing CAP RATE for the market the property is in are used to give this valuation. CAP RATES will vary with many factors including asset type, geographic and submarket location, and interest rates. If you are unsure of local CAP RATES in the area at hand you could get a good idea by looking at the going CAP RATES of for sale or similar sold properties in the area or consulting with your realtor who will be familiar with the trends. The NOI divided by the purchase price is equal to the CAP RATE. Two versions of that equation would be as follows:
NOI / Purchase Price = CAP RATE
NOI = CAP RATE X Purchase Price
CAP RATE is essentially what return you would be receiving back on your investment IF you bought a property with all cash (i.e. no financing involved) in light of a particular NOI. Even though much of rental investing properties are bought with financing, CAP RATES still provide a metric of comparison between properties in a given market and also convey how “expensive” a property purchase would be at a given NOI and purchase price. In other words, a lower CAP RATE property would be considered a more “expensive” purchase than a similar property with similar NOI but a higher CAP RATE.
Although you have no control over the going CAP RATE range in your target market, there are a multitude of ways in which you can impact NOI and it is via this avenue that you potentially have the opportunity to “force” appreciation and positively impact the value of a property. This might be important as you look to prepare a property of yours for sale to optimize the NOI and obtain the best possible sales price, or it might be important to you as you evaluate a property for purchase to see ways that you could buy at a given price but “force” that value up by some impact on NOI and thereby increase your equity in the property.
So what are some ways to impact NOI?
- Increase rents on existing under-market rental units
- Improve units on turnover to obtain better tenants at a higher rent
- Add additional revenue streams: garage rentals, on-site laundry, storage lockers
- Tighten up rent collections and improve economic occupancy
- Improve tenant lease renewals by being an exceptional landlord and also by providing renewal incentives
- Renegotiate contract services for a better price
- Institute utility bill-back system to transfer back some of the utility costs back to tenants
- Install energy efficient items in units to conserve resources
In other words, anything you can do to either increase net income or reduce expenses is going straight to an increase in NOI and therefore an increase in property value. What might not seem like an impactful change to the monthly bottom line could actually surprise you when you extrapolate that small amount over the number of units held and multiplied by the 12 months in a year and then subsequently evaluated by way of the CAP RATE. An example to illustrate: Using the NOI from the example above, say you have a 10-unit property with a monthly NOI = $4,458.33 (annual NOI = $53,500). By taking steps to improve NOI as outlined above you were able to make the following changes:
Example: 10-unit property: monthly increase per unit/monthly increased income/annual increased income
* rent increase: $20/mo/unit = $200.00/mo addtl income = $2,400.00/yr addtl income
* utility bill-back: $15/mo/unit = $150.00/mo addtl income = $1,800.00/yr addtl income
* renegotiate contracts: $75.00/mo less expense = $900.00/yr less expense
* reduce tenant turnover: $1,000.00/yr less vacancy & rehab expense
TOTAL increase to NOI = $6,100.00
In this example you were able to increase the NOI by $6,100 per year. Not only is this great because it is money going straight to the bottom line and increasing your cash flow on the property, but let’s take a look at what this does to the valuation of your property. Again, CAP RATES are very different for different markets and asset classes, but for this example I am using a CAP RATE of 6.5%. Taking the original NOI of the property and adding the $6,100 brings the new NOI to $59,600. Applying our CAP RATE of 6.5% here, you can see that monthly NOI increase of $425 equates to quite a significant increase in your property value, in this case to the tune of over $90,000! Not too bad for making some rather small changes to optimize the performance of your property, right?
original NOI = $ 53,500.00 ---------------> valuation at 6.5 CAP Rate = $ 823,076.92
increased NOI = $ 59,600.00 ------------> valuation at 6.5 CAP Rate = $ 916,923.08
"forced" appreciation= $ 93,846.15
Hopefully these simple examples give you some idea of the importance of NOI as well as the significance relatively small changes to NOI can have on the value of your property. If you’ve been involved in real estate for awhile I’m sure you will agree on this topic. If you are new to real estate and seeking to become more familiar with the application of these metrics, play around with the numbers and see for yourself how various changes to property price, CAP RATE, and NOI interplay with each other. The more facile you are with how these numbers relate to each other the better your position will be either as a buyer or a seller as well as in dealing with lenders by understanding how a lender will evaluate your property value and eligible loan amount.
Feel free to share any anecdotes or experience you have had in your real estate journey in learning about and understanding property valuation, CAP RATES, and NOI. Meanwhile, happy investing!