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When you are preparing to make an offer on residential investment real estate, usually defined as properties with 6 units or more, NOI (net operating income) is a very magic number. NOI is the basis for calculating a lot of numbers associated with an income property, but most importantly it is one of two factors that determine price.
ESTIMATED MARKET VALUE = NOI / CAP RATE
As you can see, estimated market value is the net operating income divided by the cap rate. This makes the property's cap rate also very important, but I will save that for another day.
As an investor what does this mean to you? Well, on the buying side, you want to bring that NOI down as much as possible when you are justifying your offer. Sellers tend to paint a rosy picture of the NOI on a property with phrases like It is always fully rented! Which of course we know is never the case unless the rents are under market. Which still works to our advantage.
Lets look at an example. Lets assume that we are buying a 6 unit apartment building with rents of $ 700 a month and with a cap rate of 8.5%. Expenses round out at $ 20,160 for the year giving us a NOI of $ 30,240 for the year. So plugging it into the formula above, we get:
$ 30,240 / 0.085 = $ 355,765
Simple enough, but what if the owner wasn't quite telling the truth? Owners of property never fib about numbers do they? Lets assume that they have forgotten that two units are turning over every year. That costs the property $ 1,400 in lost rent, plus another $ 200 in advertising and another $ 350 per unit in cleaning and repairs. What does that mean to you?
Those added expenses bring our NOI down to $ 27,940 and change our formula!
$ 27,940/0.085 = $ 328,705
A small change in NOI has magnified to a whopping $ 27,059 reduction in the price! This is why getting accurate financial information on a property is absolutely critical when finalizing an offer on a residential investment property.
When you get ready to make an offer on an investment property, never take the sellers work on the NOI. Look at the expenses and income for yourself. Often times the owners won't let you have access to their full information until after you have an offer on the table, but you still need to go over every detail! Some expenses to look at are:
Actual rent receipts
True vacancy rates
Cost of acquiring new tenants
Maintenance
Who pays utilities
Taxes
Property repair set asides
Management fees
These will all eat into the NOI and lower the market value. Of course once you have the property, these will also be the items you are going to want to look at minimizing to increase your NOI and market value. Remember, a small change in NOI is greatly reflected in the market value of a property. .Are you looking full ebook about this topicGet Full Ebook For This Article
