By Dan Hicks
Photo by Paul Flessland
Investment Real Estate: NOI & cash flow
While “cash flow” is probably a term most people have heard, the manner in which it is used can vary and is not always correct.
It should mean: the amount of money left over after all expenses are paid, including the financing used to purchase the property. At times, you will see a property advertised as “cash-flowing” or “positive cash flow.” That may be true for the current owner, but it does not necessarily mean it will be true for a buyer. Even if it holds true for the buyer, it still does not always mean it is a good investment option.
The question shouldn’t be, “Does it cash flow?” The question should be “How much does it cash flow?”
The primary number you need to analyze an investment property is the net operating income (NOI), which is calculated as follows:
Gross Scheduled Income – Vacancy and Credit Loss = Gross Operating Income
Gross Scheduled Income – Operating Expenses = Net Operating Income
The NOI is the income remaining after all expenses are paid. It is also the amount left to pay for the debt on the property. Among other things, the NOI can be used to determine cash flow, return on investment (ROI), market value and potential financing.
The net operating income a seller is showing is not always pertinent to a buyer. A buyer should always take the time to recast the NOI to reflect how they plan to operate the property.
Some of the factors to consider when adjusting the NOI to predict the properties performance during new ownership:
1) Vacancy – A property should always have vacancy factored in even if the property is currently 100 percent occupied. A bank and/or appraiser will normally use the greater of a five percent vacancy rate or the market vacancy rate.
Expenses (that may change from owner to owner)
2) Repairs & Maintenance (R&M)
After viewing the property, a buyer should be able to tell if the seller has been keeping up with the R&M. If it appears items have been neglected, it likely indicates that you are going to have a higher R&M expense than the seller is showing.
3) Management – At times, owners will manage the property themselves and not have a line item expense for the cost of management. If a buyer plans on hiring management, this would be an additional expense to account for. Even if the buyers plan on managing the property themselves, they may consider adding this expense as their time is also worth something.
4) Real estate taxes – Buyers should consider what real estate taxes will be after the purchase. If the property is assessed lower than the sales price, real estate taxes will likely be increasing over the next few years as the county assessment catches up to the sales price.
Other missing expenses (items the seller is taking care of personally such as lawn, snow, etc.)
5) Reserve expenses – This is an estimated expense based on the future cost to replace items such as the roof, HVAC systems, parking lots, etc. Reserves are not always used in calculating a NOI. It’s a relevant expense to consider, however, using it to determine a value somewhat depends on whether or not the comparable properties have reserves factored into their NOI.
The variance between a seller’s numbers and a buyer’s numbers is normal. It does not mean a seller is purposely inflating the numbers. It is likely the way the property is currently operating for them. It is also possible that a seller’s expenses are overstated due to inefficiencies, poor management or tax-reduction strategies.
Once a buyer arrives at an NOI relevant to their ownership, they can calculate cash flow, ROI, determine value, and determine whether or not a bank will likely finance this property based on debt service coverage ratio (DSCR).
Look for a future article to cover some valuation methods using cash flow, capitalization rate, ROI and DSCRs.
Purchasing an investment property is often one of the largest ventures a person will make. It is extremely important to thoroughly evaluate the property prior to purchasing. Bankers, accountants, real estate agents, and other investors can be valuable resources in determining weather or not the investment is right for you.
The research done prior to purchasing a property will likely be the difference in losing or making money.
Property Resources Group