The Effect of Net Operating Income on Commercial Real Estate Valuation
Smart owners and managers of commercial real estate keep a very close eye on the net operating income of their properties because of the high importance that it plays in the direct valuation of their properties. Being that the most common appraisal method is the “income approach”, higher net operating incomes equals higher property values. The reverse is also true.
Conceptually this all make sense to you, but lets take a minute and review the math behind it so you can see how important it really is. Supposing you own a $10,000,000 property, which you purchase with a cap rate of 8%. What would the net operating income be? Using the cap rate equation (% capitalization rate = net operating income/purchase price) or (8% = NOI/$10,000,000), we then solve for net operating income by multiplying $10 million by both sides of equation and we get NOI = $800,000 We also know that NOI = cap rate x purchase price, or purchase price = NOI/cap rate
Now, lets see the effects of changes in the NOI on the valuation or purchase price of the property. Let’s suppose that you increase your NOI by $1,000 during the next year. What effect would it have on the value of the property? Purchase price = $801,000/0.08 = $10,012,500 In other words, by increasing the NOI by $1,000 you increased the property’s value by $12,500. Pretty powerful stuff, huh? Just as a quick rule of thumb and knowing that cap rates will vary, just think of it like this: For every dollar increase in NOI, you increase the value of your property by $10. If you make significant property improvements that result in an increase in occupancy, the increase in valuation can be drastic.
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