Anchorage Daily News

I am continually surprised to see the number of real estate investors who do not understand the most important concept in real estate investing -- net operating income.

A real estate investment, like all investments, is basically the purchase of a future flow of money. The return on any investment, whether real estate or a security, comes from the investment's future cash flow.

The value of the investment is the value of the future flow of money. There are lots of ways to compute that value and lots of items to take into consideration. But it all starts with projecting the future flow of money.

For real estate, this flow of money is called the net operating income, or NOI. If that is not calculated correctly, then everything else in the valuation of the investment is going to be wrong. So you need to get this one right.

NOI is basically very simple: It is income minus costs. But there are a few items that you handle differently than you would think. Calculate the NOI for the first year of the investment, and then carry this forward as a projection, adjusting items for each year. An Excel spreadsheet can do this very easily and makes possible testing changes in items to see how the bottom line is affected.

The income includes rent plus anything else from the property that generates income, such as laundry machines, parking fees, signage fees, storage fees and so forth. Figure out what the income would be as though the property was fully occupied (this is called "scheduled rental income"), then subtract an amount for vacancy and credit loss. For most properties the vacancy and credit loss is 5 percent, but could be more or less depending on the character of the property, tenants, lease provisions and current vacancy. The remainder is called the Effective Gross Income.

Now subtract the costs associated with operating the property and you have the NOI.

Here is where most people make a mistake: They confuse NOI with cash flow for their ownership and include too many items as operating costs when computing the NOI.

Operating costs include items such as utilities, maintenance, advertising, janitorial, taxes, insurance and management. Also include the cost of reserves for replacing items necessary to operate the property, such as a furnace or air conditioning unit.

Do not include debt service, depreciation and costs associated with obtaining tenants. On the surface it looks as if these are costs that should be included in NOI, but they are not.

Depreciation is a noncash item for tax purposes, and the NOI is calculated on a before-tax basis. Taxes for a buyer's specific tax situation, including depreciation, can be taken into consideration after you determine the NOI.

Debt service is not included because the value of the property is generally not affected by debt. A buyer can separately look at the cash flow after debt service to see what the cash flow is with specific financing.

Costs to obtain tenants -- such as brokerage commissions, modifying a spaces layout and legal fees incurred for a lease agreement -- are taken into consideration when applying a capitalization rate to determine value. They are not deducted as a cost when determining NOI. A buyer will need to look at cash flow after these tenant-related costs.

Sellers will provide the historic income and cost information, but remember, this is their income and cost items, not yours. So you have to adjust the seller's items.

For example, rents might be below market and can be increased over time. Property taxes should be based on your purchase price, not the assessor's current valuation or the current property taxes. There may be a one-time event that is not recurring and so should not be included.

Every item in the calculation of the NOI needs to be critically evaluated to insure the NOI is accurate. Remember, you are trying to find out the future NOI from this property to accurately determine its true value and then adjust to see how it will perform for you. The better you do your homework, the better answer you are going to get.

Chris Stephens, CCIM, is a local associate broker specializing in commercial and investment real estate. His opinion column appears every fourth Sunday.

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