NOI is one of the most commonly discussed metrics in commercial real estate. It’s indisputably essential for understanding the performance of commercial real estate investments and portfolios, but it’s also often difficult to fully grasp.
Many people discuss NOI as authoritative experts, leaving others to wonder: What is it? How does it work? Let’s discuss.
NOI stands for Net Operating Income. It’s a relatively simple calculation that requires comprehensive and accurate accounting in order for it to maintain relevance as a relevant metric for your business.
Critically, NOI as a metric allows you to evaluate the performance of a property without having to factor in specific capital structures and other owner-specific details.
It’s agnostic towards such factors because it’s a straightforward calculation of money in and money out.
Additionally, NOI is best used as a comparative metric. It’s not necessarily accurate to actual profitability or net profits. While it is used in the calculation of fair market value, it doesn’t need to be precise—to-the-penny—in real life. It is, typically, a proxy figure.
NIBT is another metric similar to NOI, which is often used for similar purposes.
NIBT is Net Income Before Taxes. Like NOI, it’s a simple calculation of income minus expenses. Unlike NOI, NIBT is a metric that can be calculated at a per-property level, for a geographic area and all owned properties within it, or a total portfolio level.
Some people use NOI to calculate NIBT. Others use NIBT as a starting point and add/remove income and expenses to adjust to create NOI.
EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization, is very similar to NOI.
However, despite the similar equation used to calculate them, the inputs are different—as is the purpose of the metric.
NOI is used to calculate and compare the profitability of a piece of commercial real estate. EBITDA is used in a similar way for businesses rather than real estate. Due to their similarities, the two metrics are often compared, but unless your portfolio includes both commercial real estate and businesses, you aren’t likely to be using both.
A simple description of a NOI calculation is this:
(Total income of a revenue-generating property) – (Total operating expenses for the property)
You must calculate both income and expenses accurately in order to produce a relevant, accurate NOI figure.
NOI can be calculated manually, but in reality, the vast majority of commercial real estate owners will use accounting software to handle it for them. Gross estimates are only so helpful, so the more accurate the data and the more various factors can be included, the better it will be for forecasting and investment analysis.
Income for a revenue-generating property can cover many different income streams.
For a rental property, this is mainly made up of rent from tenants, but other income streams may include parking fees, vending machines, paid services, and more.
Income for a property varies depending on the use of the property and the surrounding assets.
Operating expenses are the class of expenses necessary to keep the property functioning but expressly do not include capital expenses. Capital expenses are typically improvements to the property, like replacing an air conditioner.
Operating expenses are expenses related to maintaining the property, such as janitorial fees, property insurance, and general maintenance costs.
These expenses are considered to evaluate the value of a property. Operating expenses therefore, doesn’t include expenses such as financing to pay for the property.As an owner-agnostic metric, it can thus be used to examine the property and determine its potential profitability before making an investment in the property itself.
Operating expenses can be calculated using historical data or using forecast data.
Expenses are often examined by breaking them down into three specific categories.
NOI also has a time dimension. It is most often an annual calculation but can be applied to any duration for which data can be calculated.
As mentioned above, NOI excludes many owner-specific costs.
What should be excluded for an accurate NOI?
Any other irregular or owner-specific cost or income is also excluded.
NOI is a good metric for use in analyzing and comparing properties, precisely because it’s difficult to manipulate. While some expenses can be embellished or manipulated, they’re a relatively minor part of the overall NOI calculation. The overall picture of a commercial property’s NOI is an excellent way to estimate how well it may perform when put into your portfolio under your usual financing and capitalization rates.
NOI can be used to benchmark a property you own against comparable properties in the area. It can also be used to compare multiple properties you’re considering purchasing to see which ones may be the best options for investment. It can additionally be used to compare properties in your portfolio and determine which ones are the best and which are the worst from their own merits.
NOI is also used to derive a number of different metrics.
It’s calculated as NOI divided by annual debt service and allows you to determine how much leeway you have in repaying financing and debt using the income provided by the property.
All of this makes NOI a fairly helpful metric to use.
There are two significant drawbacks to using and relying on NOI.
Another issue is that there’s no objective standard for what constitutes a “good” NOI. NOI is heavily dependent on context. How does this property compare to other properties in the area? How does it compare to other properties in your portfolio? A “good” NOI for one region will be different from the same NOI in a different area. Moreover, depending on your various owner-specific factors, a property with an NOI that appears bad to many investors may actually be a prime opportunity for your specific portfolio.
Relying too much on NOI can lead to situations where the reality is very different – and often worse – for the property owner.
When handling the finances of a commercial property portfolio, dozens – if not hundreds– of different factors influence the outcomes. Knowing what goes into which metric, how accurate your sources of data are, and how to use and calculate each metric is an immense task. Commercial real estate accounting is, after all, a full-time profession.
Luckily, there are many ways to help streamline this process and other financial tasks relevant to commercial real estate. For example, property taxes alone can be vastly complicated. When you’re examining a property’s NOI, knowing how it fits into your portfolio and how it may affect your tax burden is crucial to determining whether or not it would be a good investment. One of the best ways to do that is by using an excellent commercial property tax program.
Success in commercial real estate is entirely possible, but there are many pitfalls that need to be avoided. Fully understanding the metrics and data used to estimate expenses and income streams is just one part of the picture. So, if you have any questions about specific elements of commercial real estate, feel free to leave them in the comments below.
NOI is one of the most commonly discussed metrics in commercial real estate. It’s indisputably essential for understanding the performance of commercial real estate investments and portfolios, but it’s also often difficult to fully grasp. Many people discuss NOI as authoritative experts, leaving others to wonder: What is it? How does it work? Let’s discuss.
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