Chris Stephens: Correctly figuring income key to determining property value

Chris Stephens

The most common mistake I see in determining value for investment properties is incorrectly calculating a property's net income. You would think that figuring net income would fairly simple, but for real estate it isn't.

An investment property's value -- actually the value of any investment -- is based primarily on how much income the investment will produce in the future. Income is the flow of money to you.

The value of the investment is the value today of the flow of income in the future. In other words, how much will someone pay today to buy that future flow of income. So you have to get the income right to get an accurate valuation.

For real estate, we want to use the net income, which is calculated by subtracting the property's operating costs from its gross income. The technical word for real estate net income is Net Operating Income, or NOI.

Figuring the NOI for investment properties is more complicated than most investments because real estate has many elements that affect the cash flow, and those elements are accounted for one way by owners and another for tax reporting. A number of items are deductions from income for tax reporting but are not deductions for calculating NOI. For a nonprofessional this can be very confusing. Here is how to do it.

Think of the NOI as the before-tax income from a property that has no debt and is leased with the tenant paying all costs associated with the property -- all utilities, maintenance, taxes and insurance. This is often called a triple net lease, but more accurately called an absolute net lease.

Rents are the major source of income, but ancillary income such as parking fees and laundry incomes are included too.

Vacancies and how they affect income is often mishandled. Vacancies for any year may or may not accurately reflect vacancies over the long term. So instead of calculating income based on actual rents collected in the past year, calculate the income as though the property had no vacancy (Scheduled Rental Income) and then deduct a percentage that is the average long-term vacancy, say 5 percent, to get the Effective Rental Income. If the current vacancy is higher than the average you allowed for, then the NOI and value need to be adjusted to reflect the lower income until tenants are obtained.

The amount of debt an owner has on a property makes no difference to the property's value. A property with no debt has the same value as the property with debt. So loan payments and interest expenses are not considered operating costs for the NOI calculation.

Taxes also are not an operating cost for calculating the NOI. While taxes have a big effect on how much money an owner receives from a property, the amount of taxes an owner pays from the income of a property varies based on the unique tax circumstances of the owner. So taxes paid and depreciation are not deductions from income when computing the NOI.

Maintenance reserve contributions are an operating cost, at least on paper if not in actuality. Reserves are funded by setting aside a small amount (typically about 3 percent) of the annual cash flow into a fund to pay for large capital costs like a new roof or boiler.

Property management costs are an operating cost, even if the owner manages the property. This is because management is necessary to operate an investment property. If you handle the management, deduct an appropriate amount for management.

If the building is on leased ground instead of being owned by the building owner, then the land value is not included in the value of the property Only the value of the building is calculated. This can usual be done by including the ground lease payment as an operating cost, which lowers the income and the value.

When considering a property to buy, you need to look very carefully at the calculation of its NOI. You will occasionally find all kinds of manipulations to the properties' operating numbers in the sales brochure that increase the NOI and value. Look for such things as no vacancy loss deduction from the income, no management fee or reserves, or, if they are included, look for inappropriately low percentage deductions.

You may also find mistakes where items that should not be deducted from income are included. Usually these are depreciation and interest expense that are deducted from income for tax purposes but not for calculating the NOI.

These same basic concepts for determining the NOI applies to a duplex or a class A office building. The calculation just gets a lot more complicated.

Chris Stephens, CCIM, is a local associate broker specializing in commercial and investment real estate. His column appears every month in the Daily News.

Chris Stephens
Real Estate