The Net Operating Income (NOI) method of evaluation is much more precise than the Gross Rent Multiplier method. Start by taking the gross annual income from a property. Some sellers like to play games, and say, "My gross annual income is US Dollars 60,000, but if you raised the rents, did a better job of keeping vacancies down, and installed a laundromat, your gross annual income could be US Dollars 95,000." That US Dollars 95,000 is called pro forma income. You want the numbers for actual income.
Real estate agents will sometimes tell you, "The pro forma NOI is US Dollars 95,000" or even, "That purchase price is an 8% cap on pro forma NOI." Any time you see the words "pro forma" you should think "wishful thinking." Those numbers might come true, as with a new development still filling up, or they might never come true.
After obtaining the income, subtract all the annual operating expenses, which are things like taxes, insurance, management fees, repairs and maintenance, marketing expenses, leasing commissions, and utilities. Anything you spend on that property, except mortgage payments, is an operating expense.
When researching comparable properties, you can usually estimate the gross annual income from the rents being charged in the building and get a good idea of the vacancy rate. Lenders can usually tell you ratios for operating expenses, such as that apartment complex operating expenses are going to be 27% of gross potential rent. Gross potential rent is what revenues you would have if the property were 100% leased up. Most operating expenses are fixed - they do not rise and fall as occupancies rise and fall. That is why operating expenses are estimated as a percentage of gross potential rent, not as a percentage of actual rents.
Subtract annual operating expenses from annual rent. The figure you obtain is called the Net Operating Income (NOI). You divide the NOI by the capitalization rate - cap rate - to obtain a value. If you have an NOI of US Dollars 8,100, and the cap rate is 11%, then US Dollars 8,100 ÷ 0.11 = US Dollars 73,636. The property is worth US Dollars 73,636. Someone might argue with the choice of cap rate, but the NOI is what it is. In the prior example, if you used a cap rate of 10%, the value would increase to US Dollars 81,000. If you used a cap rate of 12%, the value would decrease to US Dollars 67,500.
Cap rates are market driven. They change depending on loan interest rates, the quality of property and its tenants, and demand for that particular type of property. You will have to ask lenders and experienced investors what the current cap rates are. If you can subscribe to specialized magazines or e-zines for your particular type of property, do so. They will usually have information about prevailing sales prices nationwide and current cap rates.
Generally speaking, as the quality of a property and its tenants decline in relation to what is considered first class, the cap rate will increase. That seems counterintuitive, but think about it this way: if you were going to invest cash to buy real estate, what kind of return would you want on your money, considering the risk you are taking regarding the quality of the tenants, the possibility of future major repairs, or the possibility of market changes decreasing your rents? The riskier the property, the higher return you would want.
You might want 12% on your money for a run-down strip center with a high turnover in tenants. You might be happy with 5% on your money for a brand-new strip center with tenants like Subway, FedEx/Kinkos, and a branch bank, all of which have twenty-year leases and annual rent increases. The higher return you must earn on your purchase price money, the less you can afford to spend. Cap rates work in the same manner.
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