When approaching each transaction, real estate professionals anticipate to achieve the best possible outcome. The property’s net operating income (NOI) is often the first metric they will assess in determining the property’s future cash inflow. However, this metric will not be enough for a savvy investor. In most cases, investors need to evaluate the property’s highest and best use.
Fallbacks of NOI
NOI is the property’s net rental income after operating expenses, which include:
- Janitorial services;
- Supplies; and
- Accounting and management services.
This financial metric can be easily manipulated by the sellers, especially in the year before sale. This skew of NOI by operating the property in a so-called “soon-to-be-sold” mode can be misleading for investors who are unaware or new to real estate investing.
A couple techniques sellers may use to inflate NOI and, with it, selling price of the property are:
- Artificially inflate property rental income by billing in advance;
- Basing billing on inflated estimates and collecting lump sum payments or deferring maintenance and repairs; or
- Classifying operating expenses as capital investments.
What should an investor do in this situation? Do not rely on numbers that you cannot self-reliantly verify. A zero-based budget, which is a method of budgeting in which all expenses are justified for each period, is a great tool; you as the investor should develop the numbers for such a budget.
Projected Cash Flows with Net Present Value (NPV)
When assessing the value of a property using NOI, investors usually look at a single year of earnings. However, it may be more relevant to discount net cash flow over several years. Net present value (NPV) is an analytical tool that considers the property’s projected cash inflows (such as rental income, debt proceeds and eventual selling price) and cash outflows (such as operating expenses, capital expenditures, loan principal and interest payments, and selling expenses).
NPV is generally the preferred method for evaluating a property that is under construction or a rehab project because it allows annual cash flows to fluctuate until the investment generates a more predictable income stream and qualifies for permanent financing. At the end of the discounting period (which is usually three to seven years), an investor may calculate a terminal (or residual) value. The terminal value is essentially the amount for which the property could sell for at the end of the projection period. It may also be calculated using replacement cost or comparable properties.
To calculate NPV, the investor projects annual net cash flows for a proposed property and then discounts these amounts to their present value. NPV is the sum of the present values, including the present value of the terminal or residual value. The appropriate discount rate for real estate investors generally takes into account the opportunity cost (which is the rate of return that the investor can earn on an investment that is comparable in size), risk and duration.
After calculating NPV you need to know what your results mean. A positive NPV indicates that the property has good potential or a safe factor against future underperformances. A negative NPV indicates that the investment may fall short of the target or desired yield, and as the investor you have several options: lower or withdraw your offer, increase projected cash flows (if realistic) or accept a lower rate of return on the investment.
Comparing Investments Using Internal Rate of Return (IRR)
Closely related to NPV, internal rate of return (IRR) is one of the most popular methods for evaluation and comparing potential investment returns. It can be used in comparing real estate opportunities with other investment options.
IRR is the discount rate at which NPV for an investment equals to zero. IRR is often used in conjunction with NPV for a better understanding of a potential project’s value. Most investors compare a property’s IRR to set “hurdle rate” which is the minimum rate you would expect to earn on the investment. The reasoning is that if an investment’s IRR exceeds the investor’s chosen hurdle rate, it is generally worth pursuing.
NOI, NPV, IRR—there are so many financial metrics to consider when investing in real estate property.