Never Trust the NOI
Have you ever been to the doctor and, after a thorough evaluation, he or she starts to rattle off words that sound like a foreign language? The best doctors help the patient understand the problem and the best course of action in layman’s terms. In the same vein, I want to help translate and decipher the net operating income.
This is one of my favorite topics. I look at deals every day with an advertised cap rate of X. Cap rate is defined as the net operating income (NOI) divided by the purchase price. Put another way, if you paid all cash for a property, this would be your return on an annual basis. Bad inputs equal bad outputs, so it’s wise to spend time diving deep into the components of the NOI.
I ask myself three questions when evaluating the NOI:
1. What is the current in-place income?
2. What is my future or potential income?
3. Does the past income represent reality? Is the seller being honest about all his or her expenses?
Just like everything in life, there are two ways to look at something. In our case, there is the seller’s viewpoint and the buyer’s viewpoint. The seller looks at the price of the current tax bill and the current insurance bill and states this as the true expense. While this may be true, it will not be my viewpoint. I need to project what the new tax bill and new insurance will be after a sale. This almost always makes the net income move in one direction—down. These are easy ideas to understand and overcome in negotiations.
Something more insidious is an accounting term called capital expenditures. I am not sure what the technical definition is, but what I know is how it impacts my bank account. Why is this so scary? Just like monsters that hide in the closet, sellers like to hide these expenses and call them “one-time expenses.” For example, an HVAC unit needed to be replaced last summer or we did a major roof repair in the first quarter last year. The funny thing is that it takes constant re-investment to keep properties in good repair and to keep tenants happy. We find on average, depending on the property type, it will take $1-$2 per square footper year when looked at over a five-year period. If you own a 50,000 sq. ft. multi-tenant office building, you can expect to pay almost $100,000 per year in “one-time expenses.” You may think that soundshigh, butcome talk to me after five years of ownership. How do you avoid the scary monsters? Well, you don’t—but you can plan for the true long-term cost.
This is the beauty of our “rainy day” fund. We plan for these expenses—whether it is a leasing commission, tenant improvement, or something else. By properly budgeting, we put ourselves in a position to win.
