As investors, one of our worst nightmares is to overpay for a piece of real estate. For those of you that have attended my training, some may recall that I have reiterated several times, that after a real estate closing, no one cares about you including the broker. This is why I stress the importance of understanding value and the proper use of Net Operating Income when valuing real estate. When calculated correctly, NOI is an essential number for establishing the purchase price, financing, and a future sales price for an investment property. This can be established by calculating the acquisition cap rate and disposition cap rate and understanding debt service coverage ratio. This will be discussed more thoroughly in future blogs.
Now take a moment, and ask yourself, “Do investment properties appreciate in the same respect that single family properties do?” The answer is NO. Single family and two family homes will appreciate through the effects of supply and demand as well as the absorption of the market during that specific period of time.
Here is an example that will help you better understand the effect that NOI has on appreciation. Tom purchased a strip mall four years ago with the NOI at $50,000. Today, the NOI has stayed constant at $50,000. Did the appreciation of the building increase, decrease, or stay the same throughout the years?
The correct answer is it would stay the same. If your income levels do not increase on the building, which can be done by raising the price of rent, and keeping the expenses in control, the building will not appreciate. That is why we must project the future value of the investment so that we hit our benchmarks every year. Keep in mind, you are not only buying the building, you are also buying the income stream that the building generates. Theoretically, if you don’t increase the income, you will not increase the value of your investment.
When you are in the market looking for an investment property, the seller or listing broker will provide you with a pro-forma. A pro-forma is a detailed description of all income and expenses on that specific property. So let’s be smart, before using those numbers provided to calculate a final purchase price, ask yourself, where did those numbers come from? Keep in mind, they come from the person who is trying to sell you their building. That is why they call them liars statements, so before accepting the NOI we must thoroughly examine the pro-forma using good due diligence.
Your due diligence research will give you a better indication of what is really behind the numbers. In other words, this can be described as what we call reconstructing the pro-forma. This reconstruction is our own way to understand how we as investors are going to manage our own investments. Keep in mind, typically no two investors will own and manage the building the same way.
The NOI is the remaining income after all expenses have been paid for except the debt service.
I have provided a simple formula below that will help you better understand the calculations.
Potential rental income
– vacancy and credit losses
= effective rental income
+ other income
=gross operating income
= net operating income
Some of the operating expenses that you can expect to see are management fees, monthly maintenance, vacancy rates, repairs, taxes, insurance, and utilities just to name a few.
Once you fully understand and acknowledge the importance of NOI, valuing real estate becomes that much easier. In doing so, you will be able to make smarter, faster decisions so you can cut out properties that aren’t in your favor.
Throughout the Rich Dad Education Elite Property Management and Cash Flow training course, we explore and provide many ways to value real estate through the use of NOI. Stay tuned for more helpful tips in valuing real estate.
Rich Dad Education Elite Training Property Management Course Instructor