Capital expenses and NOI

11 Replies

I've read that capital expenses shouldn't be included in an NOI calculation, but is it ok to include a per-door reserve? (By OK, I mean if I include it and use the resulting figure as reasoning for making a specific offer, will the seller think it's normal or that I'm trying to pull one over on him?)

Correct. It's normal to include reserves. The bank and appraiser will. One time capital expenses are excluded 

How many units are you talking??

The sophistication of the seller is usually based on the number of units they have.

Example 5,50,100 unit building etc. will have different sets of books and accounting procedures. Generally I find the smaller the property the sloppier the books.

This is because larger properties tend to be ran by larger commercial firms that keep and track mostly accurate and various reports lenders will require.

For reserves you will need to see the type of property and size you are going after and if you get a loan what the lender requires.

You will get push back on reserves and capex from the seller as they will say it's subjective and they are selling based on the NOI. You have stand your ground if they do not include customary items. So as an example when my clients buy a larger building the lender will make certain assumptions of (UCF) underwrite able cash flow. If the seller says they manage themselves and no fee is calculated the lender will use a safe percentage for that area ( say 6% for example) if market shows that is the standard rate on the appraisal. If the seller is claiming 100% occupancy but vacancy in the area averages 5% then the lender will take that off as well. They do this to protect their position in case of take back or foreclosure etc. If they lent based on all the sellers inflated assumptions they would take a much higher loss if things went bad. This is why it is absolutely critical to know for an area the vacancy rate and average management fee and calculate it upfront along with lender reserves. If the numbers are not adding up from what the seller is stating it's better to know upfront and explain to them WHY you won't be able to pay that price for XX reasons. If they will not comply and are looking for a sucker it's best you found that out now before spending thousands to tens of thousands only to find out they are not motivated to sell. Another gotcha is they base NOI off of unrealistic numbers and claim higher occupancy but when you go in the books you find higher vacancy ( they said 3 year average was 94% but it really was 87%) and claimed rents were 600 a door but after finding out waiving of first months rent the effective rent really was 550.

All of these little things start adding up to where you have to come back to the seller for a 700,000 reduction and they say no way etc. You learn after doing this all the time to do most of the work upfront on key metrics to save time. Hope it helps.         

Medium allworldrealtyJoel Owens, All World Realty | [email protected] | 678‑779‑2798 | http://www.AWcommercial.com | Podcast Guest on Show #47

Gretchen,

Joel makes some good points.

You need to include management fees, a cap ex reserve, and a vacancy factor.  As a lender, I would underwrite with those items included.  I am working on a loan right now where the seller included a significant tenant improvement at the beginning of the lease.  Now they want the rent underwritten as if it is market rate while it is 5 more per sf.  As the lender, I cant do that. 

Mark

The actual number for NOI does not include capital expenses. This is for tax reasons.

You can add another line item to your spreadsheet, such as, "Income after capital" and another for "Income after principle" if you are trying to see your actual monthly cashflow. 

If you are looking at the number from a buyer's perspective, then you have to do more digging. Many sellers will pull a lot of the actual repairs out of the "repair" bucket and place them in the "capital" bucket in order to make their NOI look better.

@Joel Owens  I was asking more generally because I'm putting together a property evaluation spreadsheet and wondered where to put the Reserves line item--in with the other operating expenses or outside if it. As you said--key metrics up front! 

My personal goals are to buy a smaller building to get my feet wet--not sure yet on 2-4 or 5-10 unit--and learn on the job with smaller properties so I don't make the big mistakes on the big properties. But I want to get the numbers right from the beginning.

Remember for appraisal and loan purposes 2-4 units is comparable sales and 5 plus is the income approach.

Not much net benefit going with a 5-6 unit versus a 4 unit because the loan is much better with a 4 unit property for terms. You add a couple more units and now you are getting into commercial loans that really do not make sense for smaller properties at least to me.

Medium allworldrealtyJoel Owens, All World Realty | [email protected] | 678‑779‑2798 | http://www.AWcommercial.com | Podcast Guest on Show #47

You put it outside of the expenses in your spreadsheet.  You will have net income before capital and another line with net income after capital.

@Gretchen Roberts getting back to your first post, I would include the per door reserve in your NOI when presenting to the seller. It is how you are evaluating the property after all, and you should let them know that. I don't think it looks like you're trying to put one over on them, you're just being professional in your evaluation of the operations of the property. Going further, I would also list the capital improvements required to bring the property up to standard for the market, and present those items to the seller also.

In the seller's mind they may not like that you're presenting items which value the property for less, but I think they will also see you as somebody who knows what you're talking about. That will build trust that you can actually get the deal done. 

Originally posted by @Gretchen Roberts :

I've read that capital expenses shouldn't be included in an NOI calculation, but is it ok to include a per-door reserve? (By OK, I mean if I include it and use the resulting figure as reasoning for making a specific offer, will the seller think it's normal or that I'm trying to pull one over on him?)

NOI is net "operating" income and does not include capEx. If you are trying to get a value based on direct capitalization you can ONLY do this correctly if you have access to cap rate comps. You'd verify that all comps are calculated correctly and look to see that each expense was typical for the building type and market. This will give you a tight range of cap rate comps. Select the number that best reflects your property and divide that number into your NOI. That is your market value. If it is apparent that there are necessary capEx needed immediately you'd try to negotiate that expense off the market value.

To build on what @Bob Bowling said above, which I agree with - it can be tricky to figure out market cap rate if you're just new to the market/property type. I think the best way to do it is speaking with active commercial brokers and appraisers. Call around and see what folks are getting in the area you're considering. 

I did call the person who seems like the top commercial broker around here, and she gave me the cap rates. They seem reasonable based on what I know of this market. 6-7% for the swanky quadrant of town, 7-8 for the B side of town, 8-9 for the C side, and 10+ for the war zone. 

Kind of using that in a balance with the NOI/asking price to figure out what a good offer should be. The most fascinating thing so far is that you can change a single projection and everything moves...in your favor or the seller's.

Who said math was boring? :) 

And--you guys are awesome! I appreciate all this help and advice on a Saturday.