Whenever investors come across the term net operating income or NOI, several assumptions come to mind as to how this metric is used. In multifamily investing, NOI is an instrument that’s very powerful for many reasons.
First of all, valuing multifamily assets involves more or less a different set of dynamics. Single-family homes are appraised based solely on median property values, the amenities available to homebuyers, the size of the home by square footage, among others. Multifamily assets, on the other hand, are valued based on the same factors plus the income they generate from rental fees. To put it simply, multifamily properties provide an actual cash flow which also figures in the valuation of these assets.
This is where NOI comes in. It shows how much you are going to earn from the acquired assets. It shows the health of your cash flow by determining your income from rental fees minus the expenses incurred from managing and maintaining these assets.
In a way, NOI can actually help you determine whether or not a piece of multifamily property consisting of 20 or more units would be a good (and more importantly, highly profitable) acquisition. It gives you a good picture of what your cash flow would look like based on available data.
The Cons of NOI
Just like any other real estate instrument, NOI can be an inaccurate tool when it’s improperly calculated. What adds to the complexity of NOI is the fact that property values change drastically depending on market performance. This makes it difficult to ascertain how much you will be actually earning in a not so steady property market. Aside from that, it is also difficult to arrive at a precise NOI amount when you have to include variable expenses such as taxes, loans, and expenses for property renovation and repair projects.
NOI has its limits, but it can still guide investor into getting all their money’s worth. When it comes down to searching for the best multifamily assets, making an approximation wouldn’t hurt. After all, whether you use capitalization rates or cash-on-cash (COC) to determine the value of the assets you are acquiring, NOI is one thing you wouldn’t want to disregard. I definitely have concentrated my attention on momentum plays, that is assets who have yielded great COC returns over the last 12 years.
You only need to make sure you are doing it right when calculating for NOI.
Since NOI is based on how much cash your assets are generated from tenants, it is important to look at how much you can actually earn from rentals (A1). Aside from that, you can include income from other sources, such as parking fees, cleaning services (A2) and RUBS-Utilities Bill back (A3) Once you have acquired a gross monthly rental income based on these three variables, you need to deduct the losses you have incurred from vacant units (B3). This leaves you with a gross operating income (GOI).
As you can see, we’re not there yet in terms of knowing how much income flows straight into the bank. We still have to deduct operational expenses covering property insurance, taxes, repairs, and utility costs (B4). We now arrive at a net operating income which we can use to determine overall cash flow performance.
Here’s an illustration of the formula you are going to use:
A1 + A2 + A3 = GOI
GOI – B4 = NOI
Apparently, calculating for NOI looks so simple. It’s the collection of the right data that offers the most pressing challenge. You only have to make sure you get every single detail right from the get-go. When properly determined, NOI can help you find the investment options that guarantee the best possible returns.
Increasing your NOI
NOI is a metric that shows how healthy your multifamily investments are. Sure enough, a higher NOI means these investments are profitable. It also helps you qualify for loans a lot easier since a high NOI demonstrates your capacity to make commercial loan payments. But how do you exactly increase NOI? Well, there are several options. You can open up new income streams by charging for the use of certain amenities. For example, you can charge your tenants for pool access if the property you have acquired has an indoor swimming pool.
Another option is to reduce operational costs. You can implement cost-saving measures such as installing energy-efficient bulbs to control energy consumption. You can also share utility costs with your tenants. Not only will this reduce your gross operating costs, but it also provides an added income stream to include in your NOI as illustrated in the above example.
I hope this guide helps you understand how to use and calculate NOI. It’s easy, it’s simple, and it will help you find the right investments in no time!
If you want to know more about NOI and other important details about multifamily investments, feel free to leave a comment below.