If you want to fully understand the profitability of an investment property, you must first get to grips with the property’s Net Operating Income (NOI). From this, you’ll get a clear picture of the property’s cash flow and be able to make better decisions. NOI is one of the essentials of commercial real estate, and unraveling it is key to good and predictable profits.
NOI matters in commercial real estate because it helps investors to accurately do an asset valuation, track and understand the cash flow of a property, and use it as an asset management and risk assessment tool for strategic planning and property benchmarking. NOI is key to good property management.
To understand what NOI is in commercial real estate, we’ll take you through some definitions and examples. By the end of this article, you’ll have a much clearer understanding of how it works in commercial real estate and how to apply it to your current business needs.
Using NOI For Asset Valuation
One key way to use NOI in commercial real estate is as an asset valuation tool. When investigating a property or determining the value of a current asset, getting a handle on the property’s net operating income is the first step to working out how profitable it is or will be.
How To Use NOI To Value A Real Estate Asset
To use NOI for asset valuation, follow these three steps:
- Calculate the total net operating income of the property. Do this by taking the total operating expenses for the property and subtracting it from the effective gross income (EGI) of the property.
- Calculate the appropriate capitalization rate (cap rate) for the property. A cap rate is a rate of return an investor would expect to see on an investment. The property location and type determine cap rates and may be affected by market conditions.
- Divide the NOI by the cap rate to calculate the property’s value.
Keep in mind that using NOI to determine a property’s value is not an exact science and can have some limitations. Because NOI doesn’t take into account variable factors like the current condition of local markets, the quality of the property, or the potential for future development, it can sometimes be inaccurate.
How NOI Relates To Cash Flow
A higher net operating income on a property is indicative of higher cash flow. An accurate calculation of NOI is important for any investor because it will determine the amount of money that can be expected from a property after all expenses have been paid.
In cases where money needs to be put into the property to develop it, an accurate assessment of the operating income will allow a fix-and-flip investor good insight into how much will need to be put in before making a profit. The property’s cash flow is known up-front and can help make informed decisions.
Understanding the cash flow gives an investor a real-time and fairly accurate assessment tool to make informed decisions. How a property performs in terms of cash flow may determine whether an investor can take the risk to invest or stay away.
Understanding NOI As Part Of Asset Management
Commercial real estate asset managers regularly use NOI in three ways:
- View and track their portfolio of commercial real estate assets over time.
- Identify underperforming properties.
- Make adjustments to improve a property’s profitability.
The ability to identify trends and patterns in a portfolio’s performance and react by allocating resources and managing risk is key to a stable portfolio. The information gained when NOI is done regularly on a property may make the difference between an informed decision and a knee-jerk reaction.
When the NOI of different properties in a portfolio are stacked side-by-side, it makes it easier for an asset manager to identify which properties in the portfolio are not meeting expectations. This allows the manager to make informed decisions to release the property or what improvements may be necessary to increase the property’s profitability.
Similarly, accurate operating income information could prompt an asset manager to renegotiate leases, make capital improvements, or start new marketing campaigns. Only with accurate information can strategies be put in place to improve the property’s performance.
NOI As A Risk Assessment Tool
As you may have gathered from the above points, when a commercial real estate asset manager unravels why NOI matters so much in a portfolio, it can become a risk assessment tool.
When looking for a new commercial real estate investment, performing accurate investigations to calculate the NOI of a property will give an indication of the risk an investor is taking on: Properties with a higher operating income are generally considered to be a lower-risk investment compared to properties with a low operating income.
One way it may also be used, which is not often thought about, is to identify and track the performance of properties that are more sensitive to market changes. Properties with a high NOI have a larger margin of error in terms of expenses, and these need to be tracked more closely over time.
But it is also useful when assessing an existing portfolio, either for your own calculations and due diligence or when considering taking over an existing portfolio. Knowing a property with a higher NOI is more likely to generate a positive cash flow, even if the market takes a downturn, is key information to managing any portfolio.
Why NOI Is An Essential Tool For Commercial Real Estate
If you ask and answer the question, “What is NOI in commercial real estate?” you will soon see that it is an essential tool for unraveling the essentials of commercial real estate.
But it goes further than just using it for asset valuation, determining property cash flow, and as a risk assessment tool. When it is used well and over a long period of time, NOI can assist with strategic planning and even benchmarking.
NOI calculations can be used to compare properties in different markets to see which performs well and possibly identify new markets to expand into or early divestments that need to be made.
Also, as part of strategic planning, an investor may choose to use the profits from a high NOI, and therefore high monthly profit, to improve the infrastructure of a low NOI property in the short term until the low NOI property improves.
Calculating operating income can also be used to benchmark. When you see a property that has a higher NOI than other similar properties, it shows it has a competitive advantage. Using this information to benchmark for other properties in a portfolio may unlock more profit. It also helps when setting goals in a sector or market and gives insights into trends that other management tools may not.
Conclusion
Calculating the net operating income on a property is not only good due diligence, but it is also an indispensable tool in making decisions, assessing properties, and strategic planning. Regularly checking the NOI of a property gives accuracy to asset valuations and when tracking and understanding the cash flow of a property. This gives an indication of realistic profit margins per month and is an early warning risk assessment tool. Good property management and NOI go hand in hand.