Managing Income Property

A property's NOI is a necessary part of almost any formula used to determine the value of investment property so it must be as close to a real number as possible. The present value of well maintained income producing real estate is always some multiple of it's Net Operating Income. For example: if the present value of investment capital is 10%, a property with an NOI of $6,820 might be worth about $68,820 to a new investor.

      NOI is determined by subtracting all operating expenses from gross rents. Professional investors and appraisers usually use an APOD form (Annual Property Operating Data) to determine NOI.
      Sellers and their agents, typically arrive at the advertised NOI by using gross scheduled rents and ignoring deductions for such things as uncollected rent, vacancies, redecorating, adjustments for deferred maintenance and management costs.
      Operating expenses must include almost all of the costs of owning, managing and maintaining a property, except depreciation and debt service (principal and interest payments).  They are generally broken down into the following seven categories:

Vacancy and Collection Losses: A rental property will not be occupied 100% of the time and landlords do not collect 100% of the money even when it is occupied. Some realistic allowance must be made for these losses. Real estate appraisers will often use a number between 5% and 10% of gross income. Professional investors ask to examine a seller's Schedule E from the previous two or three year's tax returns. If that isn't possible, they may research the market, select competing properties, and try to determine what real vacancy and collection losses are likely to be.

Capital Reserves: Reserves for major replacement are often overlooked when calculating an NOI. It is the money that should be set aside each month to cover the cost of replacing such things as roofs, heating and air conditioning, parking lots or structures. A capital reserve account operates similar to the escrow or impound account for property taxes and insurance that is often required by lenders. The applicable percentage of gross revenue that should be set aside depends primarily on the age and condition of a property.

Property Management: Many small property owners do not consider management expense when they value property because they intend to manage it themselves. That concept is not realistic for many reasons, and should never be used to help justify paying too much for an investment property. A buyer should ask themselves if they intend to continue working for free for the next owner, or how they will deal with an injury or illness that forces them to hire a manager.

Maintenance: The costs of properly maintaining a property are almost always underestimated by small property owners and novice investors. The owner may do much of the work without charging his time to the property, and a new investor may believe he can do the same thing. You think you can replace a toilet control assembly for less than $10 if you do it yourself, while a licensed plumber would likely charge $75 or more. But, when you consider your time; not just actually doing the work, but the trip to verify the problem, the time picking up the part and driving to and from the job, how much is it really worth? Don't forget the cost of operating and insuring your vehicle or the purchase of tools. When considering the cost of maintenance, you must include the cost paying yourself, or someone else at market rates, to arrive at a realistic NOI.

Utilities: If any are paid by the owner, they are a deductible operating expense.

Insurance: Both the normal property insurance premiums and any additional liability umbrellas you may carry are included in operating expenses.

Gross rents			$12,000
Operating Expense	Estimated	Actual
Vacancy and Collection, 5%	600
Capital Reserves, 3%	360
Management, 5%	600
Maintenance, 7%	840
Taxes	2,400
Insurance	380
Total Operating Expense	$5,180
NOI			$6,820

Tax advantages, leverage and appreciation in value, could raise the actual return on investment to considerably more than 10% and may influence how much a sophisticated investor might be willing to pay for a property. Location, condition and improving or declining market are also factors

Net Operating Income (NOI)