I asked Anthony Chara, our speaker this month, to send me a write-up on an important element of what he’s gonna teach us about apartment and multi-unit investing.
I shouldn’t have been surprised — as he is very thorough — but he sent me a terrific explanation that I want to share with you here.
How do you determine the Net Operating Income (NOI) of an Apartment Complex?
ANTHONY CHARA’S ANSWER:
There are 3 figures that go hand-in-hand when trying to determine a commercial/apartment property’s value. They are; Net Operating Income (NOI), Cap Rate (CR) and Asking Price or Purchase Price (PP). If you know 2 of the figures you can always figure out the third.
I will be talking about the NOI of a property. More specifically, how NOI is calculated as it relates to an apartment building.
We are going to start with a simplified version of how to arrive at the NOI of a property and then expand each category. Basically, the formula is: Income -Expenses (other than debt service) = Net Operating Income.
First thing, I determine the income generated by the property. I start with the Gross Potential Rental Income (GPI) or Scheduled Gross Rental Income (SGI). Both terms are used interchangeably within the industry. The GPI assumes that all apartments (100%) are rented at full market value even if some are actually vacant or discounted.
For our example, I will use a 30 unit apartment building that has all 2 bedroom, 1 bathroom units with market rents of $600 per month each. Therefore, the GPI of this complex as an annual figure will be: 30 units x $600/month = $18,000/month x 12 months = $216,000 per year of Gross Potential Income.
The second step in the equation is to determine the vacancy of the property, both physical and economic. If you have a 30 unit complex and 3 units are vacant, the vacancy is 10% (3/30 = .1 or 10%). I will not be calculating economic vacancy in this calculation due to some of its complexities. However, economic vacancy can include a few factors such as a tenant leaving in the middle of the month (or night), a non-paying tenant or ‘incentives/concessions’ given to a tenant to induce them to move in such as ‘Free Rent’ or reduced rent for a certain period of time.
For this example, I’ll use the 10% vacancy factor. Therefore, if we assume that 3 units will be vacant every month for the entire year, we would reduce our Income by $21,600. ($216,000 GPI x 10%) Keep in mind that even if you do have 3 units vacant the entire year to achieve this 10% annual rate, it may not actually be the same exact 3 units that are vacant. The vacant units will typically rotate throughout the year as tenants come and go.
The next factor we want to look at is ‘Other Income”. The most common form of Other Income is from on-site laundry facilities. Other types of Other Income can include vending machines or even cell phone towers. We add this income into our calculations to arrive at a value called ‘Effective Gross Income’ (EGI).
Let’s assume that our annual Other Income in this example is $3,120. This is how our Annual Property Operating Data (APOD) or Financials will appear if we only looked at the Income section.
Vacancy 10% ($21,600)
Other Income $3,120
Effective Gross Income $197,520 (GPI – Vacancy + OI = EGI)
Now, it’s time to focus on the Expenses associated with a complex. I will talk about the Debt Service (Mortgage Payments) in another article in greater detail. Debt Service is not taken into account when determining the Value of a complex. Some buyers may pay all cash, some may ‘exchange’ into this complex from another one and only need to finance 50% or so of the purchase price and others may need to finance more. Debt Service is not considered an Expense as it relates to NOI. It is, however, used by a finance company to determine another very important factor called Debt Service Coverage Ratio (DSCR) which I will cover under the Debt Service article.
Expenses can be summarized within 6 major categories which are; Taxes, Insurance, Management, Maintenance, Utilities and Repairs. (TIMMUR). Within each of these major categories there are subcategories, but I will only be referring to the major categories in this article.
Depending on the age, quality of the complex and when the last rehab was completed, the expenses will generally range from about 40%-50% of the EGI. For a complex which is considered ‘All Bills Paid’ (see utilities paragraph below) the expenses will generally range from 50%-60% of the EGI.
Taxes are the property taxes associated with the complex. The amount as a percentage of Effective Gross Income (EGI) can vary widely depending on the state in which the property is located and the value of the property. The seller can provide you with the amount of property tax they’ve paid during a calendar year. You may also be able to determine the amount through on-line resources such as accessing your county Tax Assessors web site. You can even have your Title Company supply this information to you once your contract is accepted and you start due-diligence prior to closing.
One thing you need to be careful about is if and when a reassessment from the sale will occur and how it will affect the property tax for this property. I would highly recommend that when you get to your due-diligence phase prior to closing, you get an estimate of what the taxes will be based on the new purchase price of the complex and use that figure in your calculations.
It’s not uncommon to have a complex that was purchased quite a few years earlier being taxed at a greatly reduced rate. When you purchase the complex, many states will reassess the property and start charging you based on the new value and you could find yourself in sticker shock. Always get an up to date estimate prior to closing from the tax assessor’s office if possible.
Insurance is pretty obvious too. This amount will vary too depending on the insurer, the state the property is located in, your experience with this type of property, how many other units your insurer is already covering for you and the type of coverage you need. Make sure you get a good policy from a reputable company. Many times your best source is to stick with the company that is currently insuring the complex. They know the building and its history. They know whether or not any claims have been filed against the property. Always get 3 estimates anyway, including one from the current provider. Providers other than the current insurer still have access to a database that will inform them of any current or prior claims against the property or policy.
The nice part about a good policy is that if something does happen to the complex, it will pay you the lost rental income while the repairs are being performed, along with helping the displaced tenants find alternative accommodations. Ask the agent for detailed information about the policy’s coverage.
Management is the person or company that will manage your tenants. I know they are called Property Managers, but the reality is that 80% of what they do is managing the tenants. I highly recommend you use a third party company to manage your tenants and not do it yourself. Why would you want to anyway? If you purchase the property the right way, you would have already calculated in the cost of management and the complex should support itself. If it doesn’t, I suggest you find another property. If the only way the property will cash flow the way you need it too is for you to manage the property yourself, go find another property. There are plenty of them out there.
Don’t always go with the company that charges the least amount. Check around. Ask for references from other owners, RE brokers or even your finance company. Good or bad, the word does spread in a community as to who to use, and more importantly, who not to use.
Management fees are determined by the size of the complex and competition in a given area. On a 30 unit complex you could pay in the range of 5%-8% of the monthly rents. Make sure the fee is based on the ‘Collected Rent’ and not the ‘Scheduled Rent”. This gives the Property Manager an incentive to collect the rent. If they don’t collect it, they don’t get paid.
Maintenance/Repair: Rather than getting into a long discussion over what the difference is between Maintenance and Repairs, I’ll spend this time talking about the difference between R&M and Capital Expenditures, sometimes referred to as ‘Cap Ex’. Considering the IRS looks at R&M as pretty much the same, don’t worry about it. If you have a nagging desire to learn more, call the IRS or just ask your CPA. My CPA just spreads out the expenses over both the R&M categories unless the price of one item/repair is above $1000. If it is, it may be considered a Cap Ex expense and the item/repair may need to be depreciated over a number of years.
Here are some things you’ll find under the R&M category; cleaning the carpet, replacing the carpet, mowing the lawn, replacing a broken window, light bulbs, unclogging toilets, fixing a hot water heater or replacing an AC unit, painting a unit, clean up of a unit, replacing a faucet or toilet; pretty much anything that you would typically repair or maintain during the life of the property on a routine day in and day out basis.
Capital Expenditures are where things can get a little tricky. What if you repair a hole in a roof and the cost is over $1000? Talk to your CPA. Mine will typically consider that a repair even if it’s slightly over $1000. However, if you replace an entire roof or all the roofs in the complex, that becomes a Cap Ex expense and the cost will need to be depreciated over time. Other items that would be considered Cap Ex would include replacing a boiler system, painting or residing the entire complex, redoing the landscaping, completing a major rehab project in which the individual pieces might all be less than $1000, but when added up costs tens or hundreds of thousands of dollars. The nice part is that Cap Ex doesn’t affect the NOI of the property. Thusly, the value of your property doesn’t drop due to some large expense like replacing the entire roof or rehabbing multiple units or the entire complex.
Maintenance and Repairs combined will average between 5%-15% of EGI depending on the age of the complex and how long it’s been since the last substantial rehab performed. Another factor that will affect where a complex will fall within this range is weather. Typically, properties that are in colder winter climates will drift towards the higher range. The warmer the climate, the lower it will gravitate. For our example I am estimating 5% for Maintenance and 5% for Repairs for a combined total of 10%.
Utilities will include, at minimum, the gas, electric and water used on the common areas of the property like the hallways, leasing office, laundry room and landscaping. Some complexes are considered ‘All Bills Paid’ which means the owner pays for most or all of the utilities, even those used directly by the tenants. The downside to this situation, which you’ve probably already figured out, is that you have little or no control over the energy consumption of your tenants. It’s not uncommon to see a tenant’s window open in the dead of winter with the heater running full blast. Most owners will try and do what they can to pass this expense onto the tenants. Sometimes that’s not easy.
You may or may not be able to charge a portion of the utilities back to the tenants. It really depends on what the market will bear. Fortunately, most new owners are doing what they can to charge the tenants. For our example, we are going to assume we are only paying for the common area utilities to include electricity for the hallways, laundry room and outside lighting, plus water for the landscaping and laundry room.
Repairs: See Maintenance above
After determining your expenses your revised APOD will look something like this:
Vacancy 10% ($21,600)
Other Income $3,120
Total Operating Expenses $88,965 (45.04% of EGI)
NOI = EGI-Op. Exp. $108,555 (54.96% of EGI)
Subtracting your total Operating Expenses (OE) from your Effective Gross Income (EGI) leaves you a Net Operating Income (NOI) of $108,555. This is a very important figure to know because it will allow you and your finance company to determine the value of the complex you’re thinking about purchasing or refinancing. The finance company will take your NOI, and, along with the average Cap Rate for similar properties in the area to determine a value range for your property.
— Hope this helps! Thanks, Anthony
Thanks, it does!
Join us for Anthony Chara’s 2 Traction REIA events this month:
Why buy 1 when you can buy 10 or 20 or even 50?
How to Grow Your Wealth with Apartment Buildings/MultiUnits
Traction Real Estate Mentors