Net Operating Income: Cutting Out the Noise

When it comes to income-producing real estate, buyers are faced with a lot of NOISE – Net Operating Income Significantly Exaggerated. So, how do you tell the real NOI from the noise? Be realistic about the gross operating income and know which operating expenses are standard – the expenses your lender will expect to see.

The industry standard for operating expenses in residential rental properties includes: real estate taxes, property insurance, repairs and maintenance, utilities, management, janitorial, and interior/exterior decorating. Is that what the seller, the seller’s agent, or even your agent is giving you? Probably not.

The first numbers an investor sees on a property are the pro forma data. A dictionary definition of pro forma designates it as an adjective, meaning 1) “Done as a formality; perfunctory” or 2) “Provided in advance so as to prescribe form or describe items: a pro forma copy of a document.” (Dictionary.com)

For our purposes, it is most helpful to return to the Latin roots of the word. Pro forma, translated from the Latin, basically means “for the sake of”. The pro forma data presents information based on assumptions that do not currently exist but “for the sake of” argument, the data assumes are true. The pro forma may present income potential under the assumptions that 1) occupancy is 100%, 2) rental rates have been raised, and 3) expenses have been cut. Meanwhile, the real numbers state that at the lower, current rental rates, and higher expenses, occupancy is significantly below 100%.

Be realistic about the gross operating income. Think like a lender. As an investor, you see the potential for raising rental rates. A lender cannot see potential. A lender can only see what is and, as such, will require three years of income and expense statements.

The good news here, in dealing with your lender, is that the standard operating expenses can now help save your loan. In the pro forma, certain standard expenses may have been overlooked, but if your lender gets her hands on the seller’s tax documents, expenses are going to jump off the page like lemmings, one after the other, in a suicidal attempt to destroy all traces of income. When you learn to think like a lender, you will see past claims that fall beyond the scope of normal operating expenses. You will see the real income and the standard expenses and will emerge, up out from the noise, with the true net operating income.

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