Net Operating Income
Net Operating Income, or “NOI”, is a commonly used term in commercial real estate. Owners, realtors, appraisers, and lenders are all familiar with this term. You should be too.
As described in “Finance Your Income Property Like a Pro“, a lender’s primary responsibility is to substantiate that the borrower, and the property offered as security, collectively meet the lender’s guidelines.
An important underwriting tool
The process of determining whether your loan application merits further consideration, is known as “loan underwriting”. This lender review includes determining the NOI of the property. Why? The NOI directly determines the property’s debt service coverage. In other words, how much cash flow is available to service the debt (make the mortgage payments). It goes without saying that an actual or anticipated shortage of cash flow will seriously erode a lender’s confidence. Your loan application will be declined or the amount applied for, significantly reduced.
How is NOI determined?
What is Net Operating Income? It’s the cash flow from the property, after all operating expenses are deducted from the gross revenue. Gross revenue will include rent, as well as other income such as parking revenue, laundry income, and signage income. Operating expenses are those which are required to operate and maintain the premises, including real estate taxes, insurance, utilities, property management fees, cleaning and maintenance. NOI is a “before-tax” item, and excludes principal and interest payments on loans, as well as depreciation and amortization, as well as capital expenditures on the premises.
How is NOI used?
NOI is used by realtors and appraisers to determine a property’s value. With knowledge of the NOI, realtors and appraisers can estimate a property’s value by applying a factor or rate to “capitalize” the NOI into an indication of value.
For the same reason, investors use NOI as a useful tool to compare properties for possible acquisition. Sellers will similarly use the NOI and apply a capitalization rate, to determine their likely list price.
Lenders use NOI to determine whether the property’s cash flow will more than sufficiently cover the required mortgage payments. Known as Debt Service Coverage, lenders look for cash flow that exceeds the annual mortgage payments, often at least 1.15 to 1.20 times, or more. This means that there will be at least $1.15 of cash flow, for every $1.00 of annual mortgage payments required. This provides the lender with a cushion, should there be an unanticipated interruption or reduction in rental income.
Understand the importance of your lender’s analysis. You can present your income and expenses with confidence, and will understand that the resultant NOI forms the basis of the lender’s loan review.