The Importance of NOI in Commercial Lending April 13, 2009
Posted by janey in : commercial finance , trackbackWhen dealing with commercial loans and commercial real estate, it is crucial to not only know, but also understand many commercial lending terms. We have put together a full glossary of commercial loan terms for you, with all of the following terms defined, among others:
- Debt Service
- Operating expenses
- DCR
- Cross Collateralization
- Deferred maintenance account
- Contract rent
- Anchor
- Fixed costs
Today, however, we are going to explore one of the most crucial terms to help in evaluating a commercial property, net operating income. Net operating income, or NOI, is perhaps the single most basic and important concept to understand, as many calculations relating to the financial strength of a commercial property are tied to this concept.
There are two basic ways to evaluate the income on a commercial property. These are contract rent and market rent. Market rent is the amount you would expect to be able to rent a space for on the open market at the time of evaluation. Contract rent, on the other hand, is the actual rent collected. Typically, market rent will be found through rental surveys, often times done by an appraiser.
When compiling your numbers, you will be using the market rent number for any vacant space in the commercial property. For all space that is currently rented out, you will use the actual or contract rent. When putting these numbers together, it is pertinent to note that if your contract rent is less than market, your commercial property valuation could suffer.
When making commercial loans, the basic value system used is the income approach, which requires the NOI to be calculated. Once you have the income for the property together, you will then need to find the total operating expenses so you can find the NOI, or net operating income. Operating expenses are just that, all of the expenses and allowances associated with your commercial property. Debt service is not included in this .
When calculating your operating expenses, you will have two different expenses. These are fixed expenses and variable expenses.
Fixed expenses are those costs that stay the same regardless of how high your vacancy might be. Real estate taxes are a good example of fixed expenses. Variable expenses are expenses that do fluctuate depending on the vacancy factor. A good example of a variable expense is security. In addition, you will usually include a replacement reserve in your operating expenses.
Once your operating expenses are calculated, you need to find your effective gross income. This is the income from the property after taking into account a vacancy factor. Subtract your operating expenses from your effective gross income and that will give you the NOI of your property. When dealing with commercial loans or commercial real estate, the net operating income is important to know, and you should feel comfortable calculating it.
You can use the NOI of a property to look at a number of aspects related to the property. When lenders make Commercial loans, value is loosely based on the net operating income. A general way to value a commercial property is to use the net operating income and a cap rate for your particular property to arrive at a value. If your net operating income is $50,000, and the cap rate in the area is 8%, the implied value of that property would be $625,000.
Commercial lenders will also look at the DCR, pretax cash flow and annual debt service of a property. These are all calculations that rely on the NOI number, making NOI a very important number to be comfortable calculating.
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