Hey Smart Guys/Gals - Question about NOI

Investor · Maui, HI · Member since 2009 · 13k+ posts · 3k+ votes

Hey, I'm working on a spreadsheet and I'm wondering:

Does the Net Operating Income include deducting the costs for the "big items" that happen every so often, like roofs, parking lots, etc? I mean, if I set aside 3% per month for those big expenses that only occur once in a blue moon, do I include subtract that 5% as part of my expenses to determine NOI or no?

thoughts? Does it depend on the investor?

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J ScottPro Member

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Investor · Sarasota, FL · Member since 2008 · 18k+ posts · 17k+ votes

13y

There's no right or wrong answer here. From a pure accounting perspective, reserves for Capital Expenditures (Capex Reserves) are typically factored below the NOI line, not above.

What that means is that they are not considered part of NOI, just as P&I is not considered part of NOI. It looks like this:

Gross Income - Expenses = NOI

NOI - P&I - Capex Reserves = Net Cash Flow

Now, in the real world, I've seen it done both ways -- some investors factor it above the line (as part of NOI) and some factor it below. Oftentimes, sellers will factor it below the line (or not at all) so as to make the value of the property appear higher (value is proportionate to NOI).

On the other hand, as a buyer, you should either factor it into the NOI, or at very least, include it in your pro-forma analysis.

The funny thing is, I once asked an appraiser if -- when valuing a property from an income perspective -- they factor in Capex Reserves or not, he said that for commercial properties there is no appraisal standard to do it one way or the other. Not sure if that's really true or not, but that's what he said.

So, I guess the answer is, it depends on what you're trying to do. If you're trying to determine if a deal is good for YOU, factor it in, either into the NOI for value determination, or into the pro-forma for the analysis. But, if you're marketing a property and are communicating value, don't include it in the NOI, and allow the buyer factor it in himself.

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Brandon TurnerPro Member
OP
Investor · Maui, HI · Member since 2009 · 13k+ posts · 3k+ votes
13y
Oh - Forgot to tag you, Joel Owens :) Figured you'd know this one!
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J ScottPro Member
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Investor · Sarasota, FL · Member since 2008 · 18k+ posts · 17k+ votes
13y
There's no right or wrong answer here. From a pure accounting perspective, reserves for Capital Expenditures (Capex Reserves) are typically factored below the NOI line, not above.

What that means is that they are not considered part of NOI, just as P&I is not considered part of NOI. It looks like this:

Gross Income - Expenses = NOI

NOI - P&I - Capex Reserves = Net Cash Flow

Now, in the real world, I've seen it done both ways -- some investors factor it above the line (as part of NOI) and some factor it below. Oftentimes, sellers will factor it below the line (or not at all) so as to make the value of the property appear higher (value is proportionate to NOI).

On the other hand, as a buyer, you should either factor it into the NOI, or at very least, include it in your pro-forma analysis.

The funny thing is, I once asked an appraiser if -- when valuing a property from an income perspective -- they factor in Capex Reserves or not, he said that for commercial properties there is no appraisal standard to do it one way or the other. Not sure if that's really true or not, but that's what he said.

So, I guess the answer is, it depends on what you're trying to do. If you're trying to determine if a deal is good for YOU, factor it in, either into the NOI for value determination, or into the pro-forma for the analysis. But, if you're marketing a property and are communicating value, don't include it in the NOI, and allow the buyer factor it in himself.
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Joel OwensBusiness Member
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Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes
13y
What are you making this for SFR?? Multifamily??

Reserves are a subjective topic and you will get a ton of different answers based on an investors net worth and how safe they want to be.

There are some that carry small reserves, others that carry large reserves, and some that carry none at all.

The baseline that I use for purchasing multifamily and for my clients is looking at the gross income of an apartment building. NOT what is showing on the schedule E's but what current market rate is.

You could find a property is getting 450 a month but recent foreclosures and short sales have driven rents to 400 a month. Even though the tenants and schedule E tax returns show a 450 per unit stream many tenants lease are coming up and they might leave if they do not get a concession to the cheaper rent the markets have changed to.

So I take gross yearly expected rents of the marketplace for that product type and do 50% costs. If landlord pays the utilities I do 60% costs. If the landlord pays utilities but the building is much older and has not been updated I go by 65% because of increased ongoing repairs in the years to follow.

Immediate repairs that are found upon inspection you deduct those (CAPEX) off of the purchase price in addition to taking off the yearly expected operating costs to get the conservative NOI projections. Sellers claiming low costs but high NOI have been sucking out the cash flow and not repairing things or just patching along so you can't count those numbers. I don't believe anything a seller says and I use my own projections for myself and my clients. I have an engineer that travels across the country for me and does a site inspection, environmental phase 1 study, and a cost reserve stable.

The cost reserve stable is where the inspector looks at all mechanicals and other vital systems to the buildings including roofs etc. and then models out based on when they think those items will reach life expectancy and need replacement. Then they give an estimate based on replacement in those years and expected labor costs. You then take this cost reserve stable and decide how much you want to set aside for repairs based on this projection. Some investors set aside zero and some 100 per door and others 300 a door. There is no hard and fast rule. Hope it helps.
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Frank Gallinelli
Rental Property Investor · Southport, CT · Member since 2008 · 160 posts · 137 votes
13y
Hey @Brandon Turner Short answer: No

Capital expenditures, capital reserves (aka reserves for replacement) always go below the NOI line. Revenue minus vacancy/credit loss allowance minus operating expenses = NOI. If you subtract capital costs or reserves, then you distort the NOI and skew the valuation based on capitalized net income.

Like debt service, these capital items are subtracted below the NOI line in order to yield the cash flow.
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Wayne Brooks
Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
13y
xxx
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Joel OwensBusiness Member
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Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes
13y
Yes operating costs and expenses are different than replacements.

The stable just shows what to plan for in expected capital reserves for what year.

If you have a 50 unit apartment building and all 50 ac units are all the same age with the same life expectancy that is different from various units replaced over time. Replacement capital costs that are spread in years out are easier to digest than large hits all at once.

This is why I get nervous with properties with high occupancy but everything is aged and nearing life expectancy. The first few years after buying you could get hit with huge costs that kill returns. I tell sellers I have to get at a higher cap to offset the expected increase in money spent for future years.
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Glenn Espinosa
Rehabber · Alexandria, VA · Member since 2011 · 446 posts · 171 votes
13y
I just think it's awesome to finish rereading Frank's book and then hopping on to BP and reading his recent posts also. Thanks BP!

Anyway, I think an important point to note, and J Scott delved into it already, is that you have to be able to analyze a property yourself and figure out how the seller is calculating his numbers and where there is potential for skewed figures. A lot of you analysis comes from the backstory regarding the property (and Joel offered a few great examples) and as an investor you have to be able to investigate that for yourself.

Beyond all that, you can come up with a baseline to gauge the property against others within the area. From there you can figure out the true value in a certain deal.
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Brian BurkePro Member
Investor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votes
13y
I agree with the above posts, capital replacements aren't part of the NOI calculation. However, they will have an impact on your return. When I'm underwriting a Multifamily property (with the help of Frank's awesome software), I am looking to achieve a specific return. Thus, I'm less interested in cap rate, and even less interested in what the seller says the NOI has been or will be. In order to arrive at an accurate depiction of return, capital replacements have to play a role. So, I deduct them from the NOI.

If you are just trying to figure out what the cap rate is, forget about capX, if you are trying to figure out if you are going to make any money on the deal, deduct the capX.

I guess that's why I have to underwrite 100 deals to buy just one...
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Brandon TurnerPro Member
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Investor · Maui, HI · Member since 2009 · 13k+ posts · 3k+ votes
13y
Thanks everyone! I knew I could count on you guys!
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Kelly P.
Orlando, FL · Member since 2012 · 113 posts · 26 votes
13y
Do you factor in a maintenance percenaget as an operating expense when calculating NOI?
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Frank Gallinelli
Rental Property Investor · Southport, CT · Member since 2008 · 160 posts · 137 votes
13y
@Kelly P. Maintenance is an operating expense, whether you estimate ut as a dollar amount or a percentage of revenue.

Postscript to the general discussion: While capital expenditures and reserves do not affect NOI, they do (as I noted earlier) affect cash flow -- and therefore they also affect your IRR calculation.

With regard to reserves, if you put them into place on Day 0, when you acquire they property, they increase the amount of cash invested. Later, if you fund your reserve account from your cash flow, they obviously decrease your cash flow. Finally, when you sell the property, if there is a balance in your reserve account, that balance effectively adds to the proceeds you receive upon sale (your final "cash flow"). All of these events affect the timing and the amounts of cash that you must use to calculate your investment's IRR.

Bottom line: While capital expenditures and reserves do not affect NOI, they can have an important impact on the investment's overall rate of return.

@Glenn Espinosa and @Brian Burke -- Thanks so much for the kind words!
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Bill Gulley
Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
13y
Larger projects will often carry a sinking fund (funds set aside for expenses due to contractual obligation to investors) inwhich case it can effect NOI on an accrual system. I doubt anyone here uses an accrual accounting system with amortized expenses guessing everyone is on a cash basis going to what J. and Frank mentioned. But as Brian mentioned, consider when buying as you will have the expense with a long holding period. Probably a better way to view capital outlay is to amortize it over the useful life, as actual expenses. IMO :)
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J ScottPro Member
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Investor · Sarasota, FL · Member since 2008 · 18k+ posts · 17k+ votes
13y
Originally posted by Frank Gallinelli:

Finally, when you sell the property, if there is a balance in your reserve account, that balance effectively adds to the proceeds you receive upon sale (your final "cash flow"). All of these events affect the timing and the amounts of cash that you must use to calculate your investment's IRR.

Just to add a related point, if you have a large balance in your Capex reserves fund, that means you very likely have some deferred (or upcoming) capital expenses, which will likely impact the resale value of the property. While maybe not dollar-for-dollar, expect the extra cash flow from large Capex reserves to be offset by a lower sales price.
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Brian BurkePro Member
Investor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votes
13y
Originally posted by J Scott:

Just to add a related point, if you have a large balance in your Capex reserves fund, that means you very likely have some deferred (or upcoming) capital expenses, which will likely impact the resale value of the property. While maybe not dollar-for-dollar, expect the extra cash flow from large Capex reserves to be offset by a lower sales price.

In a lot of cases, that is true. There are other cases where this may not be true.

For the benefit of those not familiar with CapX reserve accounts: when taking out a loan, your lender will have an engineer perform an inspection and draft a property condition report. That report will contain a useful life schedule of structural components and fixtures. The lender will use this data to conduct an analysis of how much money needs to be stashed in an account to replace the stuff that the lender thinks that you will have to replace during the life of the loan. This number is typically in the $250 - $350 per unit per year range.

Now lets say that you are buying a building with the intent of doing a significant rehab immediately after closing. During this rehab, you will be upgrading a lot of structural components and replacing fixtures that were on the lender's useful life schedule. The early replacement of this stuff renders their schedule obsolete, but good luck getting them to recalculate the reserve account contribution. In this instance, you will likely be accumulating more in the account than you will need to actually spend in additional capital improvements. If you sell in a few years, you may have a large remaining balance to be distributed without having deferred maintenance or effecting the market value.
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Billy Hills
martinsvile, VA · Member since 2013 · 90 posts · 16 votes
12y
After quite some time I finally found a answer that works for me. Thank you . Gross Income - Expenses = NOI,

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Ayodeji Kuponiyi
Investor · King of Prussia, PA · Member since 2014 · 1k+ posts · 339 votes
10y
@Brandon Turner thanks for posting this! I needed to know as well
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Geoff Bishop
Real Estate Agent · Tampa, FL · Member since 2016 · 38 posts · 18 votes
9y
Something to be aware of is that the Bigger Pockets Rental Property Calculator DOES include CapEx in NOI.
Based on the discussion above, it sounds like that is fine to do, from a Buyer's perspective, but it isn't the way one would normally do it from a strict accounting standpoint, if I am understanding correctly.
I had this question also, after researching the Investopedia NOI...
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