086: Not Your Average NOI
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Is there anything that sounds less sexy than NOI? 🤔
Maybe, but please believe us when we tell you that with the right NOI, your life can be as sexy as sipping a mai tai in Bora Bora.
If you’re already an apartment investor, 🏨 one of the terms you often hear is NOI – Net Operating Income. While there are many different numbers you need to know (we talked a lot about these our previous episodes) – gross potential rent, economic vacancy, cap rate, etc., NOI is by far the most important number in the apartment investing world.
You might be asking yourself why, and that’s where we come in.
What is NOI?
You might already know that NOI stands for Net Operating Income. Net operating income (NOI) is a calculation used to analyze the profitability of income-generating real estate investments. This formula is frequently used in real estate to quickly calculate the profitability of a particular investment.
We are going to look at the formula used to calculate NOI, go over the variables that can help achieve higher NOI, and lastly provide a real case study from one of our properties to show you how NOI truly impacts our investors’ returns. 💪💪
Let’s start with some basic math. NOI simply is calculated by taking the Effective Gross Income and subtracting it from the Operating Expense. So, if your Effective Gross Income is $200,000 and your Operating Expense is $100,000, your NOI is $100,000.
To take this a step further, from NOI, we can calculate the property’s potential value. Assuming the capitalization rate is 4%, take the NOI of $100,000 divided by the cap rate of .04 or 4%, and you’ll get a $2,500,000 valuation.
You might be thinking 🤔, “that’s great, but why is this important for me to know?” Unlike single-family homes where their value derives from comparative property’s sold price, the value of commercial assets derives from the income it generates. This is why NOI is so significant, any incremental changes in it will massively impact the property’s value.
Continuing with the sample, assume that you were able to reduce expenses by $20,000 and increase your income by $50,000. That means your new NOI is $130,000, right?
Now take the new NOI of $130,000 divided by a 4% cap rate, and the property’s value is no longer $2.5 million, it’s now $3,250,000! That’s a $750,000 increase from the original value!
Pretty magical if we do say so ourselves. We love multifamily math! The question you are probably wondering about now is: what are some of the variables that can help increase NOI?
Variables That can Help Achieve Higher NOI
Let’s refocus on our original goal of increasing NOI. Step back in time for a second and revisit your ninth-grade algebra class. Don’t worry, this will be less traumatic experience!! 🧐🧐
There are two variables in the NOI formula: Effective Gross Income and Operating Expense. This means an increased income and/or a reduction in expenses will push up the NOI.
Let’s first take a closer look at some of the things that we utilize to consistently increase income on a property. 😌
One caveat to this is that before implementing any of these strategies to increase income, you must have done your homework and surveyed competitors in the area to see what amenities and income-generating items/ activities are working for them.
We wouldn’t build a new covered parking area if we know that the rest of the properties nearby don’t charge for them…that’s just not income generating, right? You have to think smarter, not harder!
Here are some ideas for things you might see working and consider:
- Organic rent growth
- Exterior renovations
- Interior renovations
- Drive up high occupancy
- Adding additional fees and deposits, for example, pet fees, etc.
- In-unit washer and dryer rental
- Valet trash
- Utility reimbursement
- Reserved or covered parking
- Storage units
- Bike racks
- Furnished units
- Tech packages (internet/cable)
- Smart home (smart locks, thermostat, etc.)
- Short and mid-term rentals
That’s a lot of ways that you can increase your income! On top of that, another big component of NOI is to reduce your operating expenses.
A general rule of thumb 👍 is that your operating expense should be close to 50% or less of your Effective Gross Income or OER (operating expense ratio).
Keep in mind that when buying a property, don’t just dismiss properties with higher OER, because this may mean you can reduce expenses by being more efficient and by overall better operators.
The first thing and probably the easiest way to reduce expenses is to make sure you are not overpaying for any services on-site. 🤓 For example, are you overpaying for landscape? Is there anything your internal maintenance team can repair instead of calling out a plumber every time something like a toilet gets clogged?
Here are some other things to explore or use as thought starters:
- Annual preventative maintenance
- Appeal property tax assessment
- Replace obsolete light fixtures
- Use water conserving water fixtures
- Reduce property management fees
- Reduce marketing expenses
- Optimize heating and cooling system
- Purchase frequently used supplies in bulk
- Use an umbrella insurance policy that covers multiple properties
- Negotiate better utility terms
- Leverage software tools
Keep in mind that these are just ideas and not all of them will work for YOU! You have to take a look at your own strengths and weaknesses and assess areas of opportunity from there. And of course as a passive investor you don’t have to know all these nuisances, lean in on your general partners to do the bulk of the work! Passive investing is the best! ✨✨
Now that you understand the importance of maximizing your income and minimizing your expenses, let’s take a look at a real-life case study of how this has helped improve our property’s NOI.
Case Study
As lead sponsors, NOI is THE most important matrix we look at. It ultimately helps determine the health of the investment opportunity and how much returns our investors will get from investing alongside us. As a matter of fact, we use NOI for considering when to exit our property and in which ways. 🙌🙌
On one of the properties we have in our portfolio, we utilize some combination of both the income and expense items we’ve gone over. Of course, not all were implemented on day one, because that wouldn’t be physically possible, so the increase in NOI isn’t linear; however, we see that our projected NOI after year 1 was $939,484 but our actual was higher at $999,825.20.
We raised the rent organically, raised rent with renovations when we took over the property the in-place monthly rent for a 3 bedroom 2 bathroom was $1,108 and now with upgrades, we are now leasing it for $1,594. That’s a $486 jump in income. Then we added reserved parking, added covered parking, and here’s a big one reduced delinquency!
By carefully strategizing and studying the surrounding market before the purchase and by pivoting when necessary, we were able to see sizable growth in NOI throughout the pandemic, inflation hitting a 40-year high, and hikes in interest rate. 😊😊
Do you remember the episode of Friends where Ross, Chandler, and Rachel were trying to get the couch up the stairs? Ross made a careful plan and even drew out his vision, but in the end, he kept yelling PIVOT at his friends once they got the couch stuck. We don’t want you to end up stuck, so remember to pivot when necessary to save yourself some grief!
With that in mind, when we look at purchasing a multifamily apartment property, we always look for ones with high NOI or the potential for high NOI so that we can successfully scale, grow the business, and eventually sell it for 2-3 multiples.
If you implement the correct business plan, your NOI will increase! 😉
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