“All Business is the Same.”
Q: What?
A: At the very core, all business is the same in that a business (hopefully) profits from its operations, which typically involve selling goods and/or services. In doing so, the business experiences variable costs as well as fixed costs.
Q: Makes sense, but…so what?
A: Well, whether we talk about Net Operating Income (which typically pertains to real estate investments) or Gross Income or Net Income (which may be more appropriate for another type of business, such as one that makes or sells widgets), we are referring to variations of the same basic formula, which is
Revenue – Expenses = Income
It’s simply, really: three words, one mathematical operation, and you have an equation that not only explains, but also predicts, success or failure in business.
In fact, this equation not only applies to the operations of a business – it also applies to one’s household income and expenses (with a slight modification):
“Gross income minus taxes, minus monthly expenses = money left over at the end of the month.”
Most folks hope that, when discussing leftovers, the money exceeds the month.
Q: What is the most common error when calculating NOI in a real estate investment?
A: Assuming that cash flow is income.
Specifically,
a. Including debt payments within the NOI calculation is incorrect. NOI calculation doesn’t care whether you have debt on the investment or not. You pay cash or you finance – that’s your decision.
b. Capital expenditures (new parking lot) are also excluded. Yeah, be sure to save up (from previous years’ NOI) for them.
c. Appreciation has no place in NOI. Even though most real estate and businesses sell for some multiple of their income, the derivation of value is not linearly related to income. Put another way: Value comes from income; income does not come from value.
d. Depreciation has no place in NOI. As a non-cash expense, it reduces your personal income tax bill, but plays no role in the profitability of a real estate investment.
Q: What is a real world example of a bad NOI calculation?
A: Let’s say that your cash flow from a property is (-) $200 per month. Yes, it COSTS you $200 per month to keep this property afloat. And that is why you hate real estate. You may think that your NOI is negative, because you know your cash flow is negative. You tell all your friends not to invest in real estate, because it’s not profitable for you. It quickly becomes your modern day nightmare of tenants, toilets, and termites.
However, a deeper dive reveals that your mortgage payment is $1,000 per month. You have enough equity to refinance and lower your payment to $500 per month. But that’s all immaterial.
The appropriate net operating income in this case is (+) $800 per month, because the real estate doesn’t care whether you owe money on it or not.
Noted commercial lender, friend, and founder of Investors Capital Group Billy Brown (www.BillyBrown.me) has the best verbal explanation of NOI I’ve heard in a 3-minute video here:
In a recent interview, Billy went on to say that the common obfuscation of the aforementioned equation, revenue – expenses = income into the incorrectly applied revenue – mortgage payment = profit will not only hurt you, it will bankrupt you. Ironically, this is the biggest mistake that he sees new investors making. This assumption fails to consider all the typical expenses associated with real estate and incorrectly assumes that a mortgage payment is an expense of the property. Again, the property doesn’t care whether or not it is mortgaged.
“If you think a professional is expensive, wait until you see how much an amateur costs!”
As you think about that, remember that net operating income applies equally to all businesses as well as your household finances. Someone wiser than me once said, “If your outgo exceeds your income, your upkeep will be your downfall.”
Until Next Time,
Dr. Lee Newton
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