Escalation clauses, which specify how much the rent paid by each tenant will increase each year, will determine the pace of growth in rental income from existing tenants. The most important determinant of the former are the rents paid by the tenants of the property.
Important Components of Net Operating Incomeįrom the formula above it is clear the most important components of the NOI calculation are the Gross Effective Income and operating expenses. Thus, in this example, the market price is 10 times greater than the NOI produced by the property. Operating expenses are the sum of the following expenses: Thus, the third term of formula (1) represents the amount of operating expenses that are recovered from the tenants. Notice that typically commercial leases include clauses through which a significant portion of operating expenses is recovered from the tenants. of Units * Market Rent (per unit) for residential properties (4) PGRI = Net Leasable Area * Market Rent (per sq. PGI = Potential Gross Rental Income (PGRI) + Other Income (3) NOI = Effective Gross Income (EGI)– Operating Expenses + Recoveries (1)ĮGI = Potential Gross Income (PGI) – Vacancy & Bad Debt Allowance (2) In particular, it is important in estimating the Net Income Multiplier, and the internal rate of return (IRR) of a property investment.
The Net Operating Income is also a critical part of the Income Statement, the Cash Flow Statement and the calculation of the return of a property investment. Thus, the debt service is the sum of the monthly payments due to the lender on an annual basis per the loan contract. The NOI and debt service used in the above formula refer to annual numbers. The formula for the Debt Coverage Ratio is:ĭebt Coverage Ratio = Net Operating Income / Debt Service From a bank’s perspective, the larger the debt coverage ratio, the better. Most lenders require a minimum DCR of 1.1 to 1.3 when providing commercial property loans. A debt coverage ratio below 1 indicates that the net operating income produced by the property is not sufficient to cover the payments for the loan, while a debt coverage ratio above 1 indicates that such expenses are covered by the NOI of the property. The NOI is also necessary for the calculation of Debt Coverage Ratio or DCR, which provides to lenders and investors a measure of a property’s income-earning ability in terms of covering its operating expenses and mortgage payments. The other two inputs for the calculation of the index are property price appreciation and mortgage rates. To understand the importance of NOI in assessing a property investment, consider that it is one of the three key inputs used to calculate FreddieMac’s Apartment Market Investment Index. In that case, forecasts of the exit cap rate and the property’s NOI during the anticipated year of sale will need to be used in applying this formula. The above formula is also typically used for the calculation of the resale price of a property upon exiting an investment. The market capitalization rate (or cap rate) can be calculated by evaluating recent comparable sales transactions in the local market. Thus, if the Net Operating Income of a property and the market capitalization rate are known, the investor can produce a quick and rough estimate of the value of the property. Property Value = Net Operating Income/Market Capitalization Rate According to the simple version of this approach, the value of an income producing property can be calculated as: Secondly, the NOI is a key number in evaluating a real estate investment because one of the major methods used by industry professionals to determine the value of a commercial property is the income capitalization approach. The acquisition cost in the above formula should not include only the purchase price but also all other costs associated with the purchase, such as consultant fees for due diligence, legal, market studies, etc.
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How to Apply the Discounted Cash-Flow Model