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There are 3 figures that go hand-in-hand when trying to determine a commercial/apartment property's value. They are Net Operating Income (NOI), Cap Rate and Asking Price. If you know 2 of the figures you can always figure out the third. This month, we'll be talking about the NOI of a property. More specifically, how NOI is calculated as it relates to an apartment building. I'm going to start with a simplified version of how to arrive at the NOI of a property and then expand each category. Basically, the formula is: Income - Expenses (other than debt service) = Net Operating Income.
INCOME: The first thing we need to determine is the income generated by the property. We start with the Gross Potential Rental Income (GPI) or Scheduled Gross Rental Income (SGI). Both terms are used interchangeably within the industry. The GPI assumes that all apartments (100%) are rented at full market value even if some are actually vacant or discounted. For our example, we will use a 30 unit apartment building that has all 2 bedroom, 1 bathroom units with market rents of $600 per month each. Therefore, the GPI of this complex as an annual figure will be: 30 units x $600/month = $18,000/month x 12 months = $216,000 per year of Gross Potential Income. The second step in the equation is to determine the vacancy of the property, both physical and economic. The physical vacancy is pretty obvious. If you have a 30 unit complex and 3 units are vacant, the vacancy is 10% (3/30 = .1 or 10%). I will not be using economic vacancy, also known as ‘Credit Loss’, in this calculation due to some of its complexities. However, economic vacancy can include a few factors such as; a tenant leaving in the middle of the month (or night), a non-paying tenant or ‘incentives’ given to a tenant to induce them to move in such as ‘Free Rent’ or reduced rent for a certain period of time. For this example, I’ll use the 10% vacancy factor. Therefore, if we assume that 3 units will be vacant every month for the entire year, we would reduce our Income by $21,600. ($216,000 GPI x 10%) The next factor we want to look at is ‘Other Income”. The most common form of Other Income is from on-site laundry facilities. Other types of Other Income can include vending machines or even cell phone towers. We add this income into our calculations to arrive at a value called ‘Effective Gross Income’ (EGI). Let’s assume that our annual Other Income in this example is $3,120. This is how our Annual Property Operating Data (APOD) or Financials will appear if we only looked at the Income section. INCOME GPI $216,000 Vacancy 10% ($21,600) Other Income $3,120 Effective Gross Income $197,520 GPI – Vacancy + OI = EGI
EXPENSES Now, it’s time to focus on the Expenses associated with a complex. I will talk about the Debt Service (Mortgage Payments) in another article in greater detail. However, just know this; Debt Service is not taken into account when determining the Value of a complex. The reason is because not everyone has the same need to finance a complex. Some buyers may pay all cash, some may ‘exchange’ into this complex from another one and only need to finance 50% or so of the purchase price and others may need to finance more. Debt Service is not considered an Expense as it relates NOI. It is, however, used by a finance company to determine another very important factor called Debt Service Coverage Ratio (DSCR) which I will cover under the Debt Service article. Expenses can be summarized within 6 major categories which are; Taxes, Insurance, Management, Maintenance, Utilities and Repairs. (TIMMUR). Within each of these major categories there are subcategories, but I will only be referring to the major categories in this article. Depending on the age, quality of the complex and when the last rehab was completed, the expenses will generally range from about 40%-50% of the EGI. For a complex which is considered ‘All Bills Paid’ (see utilities paragraph below) the expenses will generally range from 50%-60% of the EGI. Taxes, of course, are the property taxes associated with the complex. The amount as a percentage of Effective Gross Income (EGI) can vary widely depending on the state in which the property is located. A seller can provide you with the amount of property tax they’ve paid during a calendar year. You may also be able to determine the amount through on-line resources. One thing you need to be careful about is if and how a reassessment from the sale will affect the property tax for this property. I would highly recommend that when you get to your due-diligence phase prior to closing, you get an estimate of what the taxes will be based on the new purchase price of the complex and use that figure in your calculations. It’s not uncommon to have a complex that was purchased quite a few years earlier being taxed at a greatly reduced rate. When you purchase the complex, many states will reassess the property and start charging you based on the new value and you could find yourself in sticker shock. Always get an up to date estimate prior to closing from the tax assessor’s office if possible. Insurance is pretty obvious too. This amount will vary too depending on the insurer, the state and the type of coverage you need. Make sure you get a good policy from a reputable company. Many times your best source is to stick with the company that is currently insuring the complex. They know the building and its history. They know whether or not any claims have been filed against the property. Always get 3 estimates anyway, including one from the current provider. The nice part about a good policy is that if something does happen to the complex, it will pay you the lost rental income while the repairs are being completed, along with helping the displaced tenants find alternative accommodations. Ask the agent for detailed information about the policy’s coverage. Management is the person or company that will manage your tenants. I know they are called Property Managers, but the reality is that 80% of what they do is managing the tenants. We highly recommend you use a third party company to manage your tenants and not do it yourself. Why would you want to anyway? If you purchase the property the right way, you would have already calculated in the cost of management and the complex should support itself. If it doesn’t, I suggest you find another property. Don’t always go with the company that charges the least amount. Check around. Ask for references from other owners, RE brokers or even your finance company. Good or bad, the word does spread in a community as to who to use, and more importantly, who not to use. Management fees are determined by the size of the complex and competition in a given area. On a 30 unit complex you could pay in the range of 5%-8% of the monthly rents. Make sure the fee is based on the ‘Collected Rent’ and not the ‘Scheduled Rent”. This gives the Property Manager an incentive to collect the rent. If they don’t collect it, they don’t get paid. Maintenance includes things such as landscaping, windows, painting, roof replacement and carpets. Items that have an expected life span and can typically be planned on ahead of time. Maintenance and Repairs combined will average between 5%-15% of EGI depending on the age of the complex and how long it’s been since the last substantial rehab performed. For our example I am estimating 5% for Maintenance and 5% for Repairs for a combined total of 10%. Utilities will include, at minimum, the gas, electric and water used on the common areas of the property like the hallways, leasing office, laundry room and landscaping. Some complexes are considered ‘All Bills Paid’ which means the owner pays for most or all of the utilities, even those used directly by the tenants. The downside to this situation, which you’ve probably already figured out, is that you have little or no control over the energy consumption of your tenants. It’s not uncommon to see a tenant’s window open in the dead of winter with the heater running full blast. Most owners will try and do what they can to pass this expense onto the tenants. Sometimes that’s not easy. You may or may not be able to charge a portion of the utilities back to the tenants. It really depends on what the market will bear. Fortunately, most new owners are doing what they can to charge the tenants. For our example, I’m going to assume we are only paying for the common area utilities to include electricity for the hallways, laundry room and outside lighting, plus water for the landscaping and laundry room. Repairs include items that you may not generally be able to plan on such as replacing burnt out light bulbs, a broken window, a hole in the roof, a diseased or dead tree or shrub, a door lock that’s worn out, a clogged toilet or drain and so on. You can set a budget for these items, but no one can typically anticipate exactly when the next light bulb will burn out or when a tenant’s child will flush a Barbie Doll or GI Joe down the toilet. Just like Maintenance, you budget for these things the best you can. Over the years you can get pretty good at estimating these items. As stated in Maintenance, both Maintenance and Repairs combined will run from 5%-15% of your EGI. Another factor that will effect where a complex will fall within this range is weather. Typically, properties that are in colder winter climates will drift towards the higher range. The warmer the climate, the lower it will gravitate. For our example I’m going to use a 5% estimate for Repairs too. After determining your expenses your revised APOD will look something like this: INCOME GPI $216,000 Vacancy 10% ($21,600) Other Income $3,120 EGI $197,520 EXPENSES Taxes $22,105 Insurance $8,592 Management $13,826 Maintenance $9,876 Utilities $24,690 Repairs $9,876 Total Operating Expenses $88,965 (45.04% of EGI)
NOI = EGI-OE $108,555 (54.96% of EGI) Subtracting your total Operating Expenses (OE) from your Effective Gross Income (EGI) leaves you a Net Operating Income (NOI) of $108,555. This is a very important figure to know because it will allow you and your finance company to determine the value of the complex you’re thinking about purchasing or refinancing. The finance company will use this figure, along with the average Cap Rate for similar properties in the area to determine a value range. I’ll write about Cap Rate and how it’s used in conjunction with the NOI to determine an apartment’s value in next month’s newsletter. ‘Til then, have a great month! |
