“What’s the bottom line for this project?” Everyone wants to know what the bottom line is – the profit or cash flow. It’s the money in your pocket after all the total income and expenses are accounted. Yet, we don’t evaluate deals based on their current cash flow. Sure, a large cash flow is nice, but it’s a poor way to determine if a deal is a good one or not. Let’s talk about why with a ridiculously simple example.
Let’s say you have owned a multifamily property for ten years and you are slowly paying down a mortgage. I’ll keep the numbers small for simplicity, but typical multifamily properties will have larger numbers. We’ll say that your mortgage was set up ten years ago when you bought this investment as a nest egg and planned to pay down the mortgage over the course of twenty years and then sell it for a nice chunk of money.
Unfortunately, circumstances in your life changed and you now have to sell the property. Of course, you’d like to know what it is worth. You know that it brings in $1,000 a month in rent and your expenses (utilities, management, insurance, tax, repairs, etc.) come to $500 a month. You have a mortgage that costs $450 a month and you spent $300 last year on a new dish washer for the place. Averaged out, that dish washer cost you $25 a month. You figure out your total expenses are $500 (utilities, etc.) + $450 (mortgage) + $25 capital expenditure = $975. You pat yourself on the back for making a bottom line cash flow of $25 x 12 months = $300. You know the going cap rate for rental properties in your town is 6%. Doing the math, you value your property at $300 / 0.06 = $5,000.
$5,000! Something Must be Wrong Here
Being a smart investor, you remember that the property’s valuation based on the cap rate uses the Net Operating Income, not the cash flow. You should have used the NOI to do that calculation
The Net Operating Income
The NOI is a way to give you an apples-to-apples comparison across properties. Purchasers would be wise to use it as well. Think about the mortgage you had on this place – you set it up long ago with the plan to pay down the mortgage quickly. You were willing to accept higher monthly payments to achieve that goal. You can’t expect a new buyer to have the same goal.
The new buyer might have a different credit score. She might have a different down payment. She probably will not have to put in a new dish washer. She should expect to put in certain typical amounts for new appliances, though. Because we want that apples-to-apples comparison, we take the variable expenses off the bottom line later.
We want to take the income and subtract from it all the typical expenses that happen in a year. We call these operating expenses. When we subtract them from the income we get the Net Operating Income. It’s that simple.
The Net Operating Income is the total of income minus operating expenses.
For your property, the NOI is the yearly income (12 x $1,000 = $12,000) – operating expenses (12 x $500 = $6,000) = $6,000. Using the 6% cap rate, your value is now $6,000 / 0.06 = $100,000.
The NOI does not include the mortgage, capital expenditures, or investor payments. So, go ahead and sell your property, just make sure that you use the NOI correctly when evaluating the next one.
