Net Operating Income - Show Me The Money
NOI and cap rates are the dynamic duo when it comes to evaluating cash flow in net lease investment opportunities.
How much cash is going into my pocket? That’s a common question every investor asks. For net lease investors, the answer lies in the net operating income (NOI). Conducting due diligence on any real estate investment involves sifting through a variety of different financial data points and metrics. Two that rise to the top when it comes to understanding Pricing and Valuation in a net lease deal are NOI and capitalization rates or cap rates.
Cap rate is a standard part of the lexicon for any real estate investor – even for those who can’t quite recall the formula behind it. The term is used frequently when discussing net lease investments. The cap rate is a calculation used to determine the potential return or yield on an investment. NOI is arguably the more important metric of the two. Why? It’s all about the cash flow – the money that is literally going into your pocket.
NOI also pays a critical role in that cap rate formula, (Capitalization Rate = NOI / Price). Effectively, the NOI and cap rate work in tandem as determinants of pricing. NOI is the foundational contributor to determining the value of a net lease property. The higher the NOI, the higher the value or price you will likely pay for a property. The cap rate is the lever that adjusts the pricing up or down based on holistic 360-degree valuation.
Gross Rental Income – Expenses = Net Operating Income (NOI)
NOI is the cash flow a property delivers after expenses are paid. The expenses involved in operating a typical commercial real estate property include things like maintenance, repairs, insurance premiums and utilities. However, in a NNN property, the tenant is responsible for all of those costs. So, the out-of-pocket cost for an owner is ZERO, meaning the monthly rent payment is pure cash flow for the property owner. In other words, Gross Rental Income = Net Operating Income for NNN investors.
The cash flow alone is huge incentive for owning NNN assets. Another big incentive right behind that is zero management headaches. NNN property owners don’t bear the expense of dealing with maintenance, repairs and other costs. They also don’t have the headaches of active management, such as tenant complaints or midnight phone calls about leaking pipes. NNN investments provide steady cash flow (NOI) on long-term leases guaranteed by national tenants. Thus, net lease investors can simply sit back and enjoy the passive income and their freedom.
How to increase your NOI
As mentioned above, NOI has a direct correlation to Pricing & Valuation.
Looking at the equation [Price = NOI / Cap Rate] we can see that the higher the NOI value, the higher the pricing or valuation of the property.
For example, let’s say a Taco Bell has $200K/year for the NOI. At 6% cap rate, the value would be Price = $200K /6% = $3.33M.
If we add another $50K to the NOI to $250K/year, while keeping the cap rate constant, the price jumps to $4.17M ($250K / 6%) – a significant $840K difference in pricing or valuation.
So, how do owners raise their NOI and market value of properties? The simple answer is through built-in rent increases. About three-fourths of all net lease deals have leases with built-in rent increases or gradual step-ups in rent incorporated into the lease at set intervals. There is no renegotiating terms year after year, those rent steps are imbedded within the lease. Rental rate increases are often structured at pre-set levels, such as 1-2% every year, or 5-10% increases every 5 years across a 15-year lease. Those rent increases also apply to lease renewal options that extend beyond the initial 15- 20 year base term.
Scheduled rent increases are standard practice for regional and national name brands such as Burger King, Hardee’s, Aldi’s, Firestone, Circle K, 7-Eleven and others. Thus, built-in rent increases are key to grow your NOI over time. NOI growth also can help to offset and decrease in valuation that occurs over a hold period due to an aging building or maturing lease terms.
Consider your future NOI
NOI is an important metric investors use to vet current and future investment performance. NOI will give you a good snapshot of pricing. However, it is equally as important to look at the lease terms and recognize any rent increases that could raise the NOI over time. Are you getting a good deal, or perhaps paying too much? In most cases, the rent increases – higher future NOI – are often baked into deal pricing. All things being equal, triple net lease properties that offer rent increases tend to have lower starting cap rates (more pricey) than those tenants with no increases during term or with lower increases during term.
One should always look at the total cashflow over their respective projected ownership timeline or holding period. Our Net Lease Earning Calculator offers a good first step into exploring net lease investment options. Investors also can conduct a more advanced analysis involving time value of money such as net present value and internal rate of return (IRR). In addition, it is important to view rent increases as one of several key criteria when evaluating a deal. At Touchstone Commercial Partners, our philosophy is to take a holistic 360-degree analysis of a deal that includes the four cornerstones of valuation – tenant, location, property and competition.
To learn more about whether a NNN investment property is the right fit for your financial and lifestyle goals contact Andrew Vu at 415-539-1120 for a complimentary strategy consultation.
