NOI - To include or don't include Capital Improvements
Member since 2009 · 204 posts · 23 votes
For all you veteran ComREI's, I've seen PNL's that have included Capital Improvements (although, they were not categorized under Expenses, they were a Sub-category of Other Costs)....so the question is, to include or not include Capital Improvements when calculating NOI?
Bonus: I've also seen Contractors as an Expense (sometimes individually listed like Paint Contractors, Roof Contractors and sometimes just all lumped together into one). How can you know which Contractor Expenses are related to operational expenses and which ones are related to Capital Improvements?
I use a discounted cash flow model when analyzing a buy and hold property. The model has considerations for capital expenses. Whenever I look at a deal I complete the model as completely as possible in order to gauge the best understanding of how profitable a prospect is.
If you have the numbers, use them!
The last point- is all three need to work for me or I do not want to own the property... UNLESS I am building upside into a community, then I am always looking at the last two options because I know I am feeding time, money and effort into the first year or two...
Also- the programs are inexpensive- so everyone should own them and know how to use them...
While many defend their favorite way of calculating alternates, cap rate traditionally includes operating expenses only; not capital expenses. This can produce opportunities since not everyone understands the difference between the two. Instead of merely screening properties using the cap rate, it occasionally makes sense to review the expenses behind the calculation.
Not long ago, I was presented with an extremely undervalued deal from a very large commercial brokerage that didn’t appear so at first blush from the cap rate. In this case, the P&L included capital expenses which dramatically understated the NOI, the associated cap rate, and the resulting cash flow â€" thereby leaving a lot of meat on the bones. (As an aside, I was screwed by my broker who was apparently such a good friend with the seller’s broker that he revealed my financial evaluation to him. The seller’s broker promptly called to thank me, as if I was his good friend, and changed his offering brochure and price. To say I was steamed would be an understatement. But I digress…)
Cap rate should not be used to value, but instead should be used to screen.
Jeff
1) You don’t know if the person who wrote the software knew what he was doing and it’s often hard to check. Out of curiosity, I downloaded the Real Benefits software noted above and it’s consistent with others I’ve seen – the formulas are hidden and password protected. They do this so no one copies the spreadsheets – as if a P&L, cash flow, or amortization table is proprietary.
In fact, there are some calculations, such as capital gains and the resulting taxes that are personalized and subject to interpretation, so you have to know what the software assumes. Depreciation is another. While spreadsheets as these are impressive and lenders and the uninitiated love to see them, you generally only need a few simple calculations to evaluate a deal and it’s safest to do them by hand on your own.
2) Canned software does not necessarily provide you with the metrics important to you. For example, I use ROI to buy and ROE to sell. That is, when the anticipated ROI exceeds my investment criteria, I pursue the deal. My exit strategy includes selling when the ROE falls below a certain level. You can’t customize canned software to provide these calculations or modify it as your criteria changes. I suggest it’s better to be able to calculate these values by hand and write your own spreadsheet to automate them, than rely on someone’s interpretation.
My longstanding recommendation to review 100 properties on your own, before you make your first commercial offer, still stands. Good luck.
Jeff