Net
Operating Income: Cutting Out the Noise
by
Wade Ogletree
When it comes to income-producing real estate, buyers are faced with a
lot of NOISE—Net Operating Income Significantly Exaggerated.
So, how do you tell the real NOI from the noise?
Be realistic about the gross operating income and know which operating
expenses are standard—the expenses your lender will expect to see.
The
industry standard for operating expenses in residential rental properties
includes: real estate taxes, property insurance, repairs and maintenance,
utilities, management, janitorial, and interior/exterior decorating.
Is that what the seller, the seller's agent, or even your agent is giving
you? Probably not.
The first
numbers an investor sees on a property are the pro forma data.
A dictionary definition of pro forma designates it as an adjective,
meaning 1) "Done as a formality; perfunctory" or 2) "Provided in
advance so as to prescribe form or describe items: a pro forma copy of a
document." (Dictionary.com)
For our
purposes, it is most helpful to return to the Latin roots of the word. Pro forma, translated from the Latin, basically means
"for the sake of". The
pro forma data presents information based on assumptions that do not currently
exist but "for the sake of" argument, the data assumes are true.
The pro forma may present income potential under the assumptions that 1)
occupancy is 100%, 2) rental rates have been raised, and 3) expenses have been
cut. Meanwhile, the real numbers
state that at the lower, current rental rates, and higher expenses, occupancy is
significantly below 100%.
Be
realistic about the gross operating income.
Think like a lender. As an
investor, you see the potential for raising rental rates.
A lender cannot see potential. A
lender can only see what is and, as such, will require three years of income and
expense statements.
The good
news here, in dealing with your lender, is that the standard operating expenses
can now help save your loan. In the
pro forma, certain standard expenses may have been overlooked, but if your
lender gets her hands on the seller's tax documents, expenses are going to jump
off the page like lemmings, one after the other, in a suicidal attempt to
destroy all traces of income. When
you learn to think like a lender, you will see past claims that fall beyond the
scope of normal operating expenses. You
will see the real income and the standard expenses and will emerge, up out from
the noise, with the true net operating income.
END
Cash
Flow: In the Right Direction
by
Wade Ogletree
Cash flow
can be two of the most beautiful words in real estate, but, like the tide, cash
can flow in two directions. It is
overly simplistic to state that a positive cash flow is always the goal. In some cases the only profit in a property is the after tax
return on investment, but we will set that consideration aside for the moment
and concentrate on a positive cash flow, as if that alone were the ultimate goal
of investing. To achieve that goal,
we must first understand what cash flow really is.
Cash flow
sounds like it should be intuitive, and in a sense, it is.
When all is said and done did you make or lose money on a particular
investment? Intuitively, that is
cash flow, be it positive or negative. Of
course, cash flow is also the end result of a list of terms: gross scheduled
income, gross operating income, and net operating income.
Each of which plays an important role in understanding a potential
investment's profitability. By understand each term, we can see the chain of income and
expense that ultimately leads us to cash flow.
We being
with gross scheduled income which is the theoretically highest possible income
at a given rental rate. It assumes
no vacancies. When you account for
those vacancies, then you have the gross operating income.
Net
operating income is what you have left after your standard operating expenses. Operating expenses for residential rental properties may
include: real estate taxes, property insurance, repairs and maintenance,
utilities, management, janitorial, and interior/exterior decorating.
All that gets subtracted from the gross operating income to determine the
net operating income.
To
finally determine your cash flow, you must now take your debt service into
account. Subtract that from your
net operating income, and your result is the cash flow.
A positive cash flow means you made a before tax, cash profit.
A negative cash flow means you had to go into your other income to
support the property. There are many factors that can make a property with a
negative cash flow profitable, but, especially for the small investor, a
property with a positive cash flow—even a small one—has the ultimate
advantage of not impacting the investor's other finances.
The fact that the property pays for itself allows the small investor to
hold on to it comfortably while looking forward to further profitability in
equity and tax deductions.
The key
to creating a positive cash flow is simple and yet sometimes temporarily
elusive. We understand intuitively that higher income and lower
expenses will give us that positive income.
Sometimes the location of the property is key. Property taxes in California and Florida are high, while they
are low in Alabama. Of course,
rental rates are much lower in Alabama, too, unless you can take advantage of
prime locations like Alabama's Baldwin County.
There a landlord can enjoy higher rates and lower property taxes.
Even in a
prime location like Baldwin County, however, rental rates will not be consistent
with purchase prices. There are
windows of opportunity where you can buy a property and charge enough rent to
generate a positive cash flow. At
other times, prices skyrocket while rents lag behind.
That means the increased debt service will not be offset by increased
rents, at least, not at first. The
industry follows this cycle repeatedly, and when it does, we are reminded of an
old axiom temporarily forgotten: most rental properties do not make a profit for
the first two years.
Sometimes,
ironically, the key to creating a property with a positive cash flow is to hold
one with a negative cash flow in a market where rents will rise.
As an alternative to supporting a negative cash flow, an investor may
choose to forgo building equity instead. An
interest-only loan will reduce debt service and may create a positive cash flow.
The investor will not be building equity but will be enjoying the
benefits of the tax deductions. The
lender can fashion the loan to shift to normal amortization after a set
interval, by which date rents should have had time to rise.
END
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