NOI stands for Net Operating Income. It is a property’s revenue minus its operating expenses. Operating expenses include things like utilities, insurance, maintenance, and repairs.
Understanding NOI is important for property valuation and investing. It is also crucial to understand the reason we want to increase it, and how we can do so. The primary means of increasing NOI are increasing revenues and decreasing expenses.
Table of Contents
- Importance of Net Operating Income
- Increasing NOI through Increasing Revenue
- Increasing NOI through Decreasing Expenses
1. Importance of Net Operating Income
Investors and appraisers use net operating income (NOI) when determining the value of an investment property. Appraisers use NOI to arrive at appraised value through the cost approach. Investors use it to determine how much they should pay for a property. Property owners use it to determine how much they can sell their property for.
How is NOI used by appraisers and commercial real estate investors to arrive at a property value?
By dividing the NOI by the asset’s capitalization rate (cap rate), you are calculating the property value. This is useful when analyzing a property for purchase or determining a sales price range for a property.
NOI Has a Huge Impact on Property Value
Looking at the chart of formulas below, NOI’s impact on property value is apparent. In hot markets where a 5% cap rate is not uncommon, a small expense reduction can have a 20X impact on property value.
Imagine saving $5000 per year on utilities, and seeing the value of the property immediately increase by $100,000. When cap rates are dropping, the actions we take to generate revenue and reduce expenses have amplified effects.
2. Increasing NOI through Increasing Revenue
Increasing revenue is one way to maximize NOI on a property.
Raising rents, adding amenities that lead to more revenue streams, and increasing the number and amount of non-refundable deposits and fees are all great ways to do this.
You can begin raising prices by focusing on adding value to the property in areas that will demand higher rents.
In kitchens, focus on installing quality countertops. Granite is usually a hit and lasts much longer than cheaper materials like formica or butcher’s block. Putting in stainless steel appliances goes a long way as well.
Installing durable flooring like vinyl planks in the property will last longer and look better than carpet. Painting the property light grey brightens the space, making it feel much larger.
Granite countertops, high-traffic capable floors (tile is great), and stainless steel fixtures are a no-brainer in bathrooms. Kitchens and bathrooms get the most use and traffic, and spending more money on quality materials can make sense. Not only will they attract higher rents, but they will last longer and require replacing less often.
Improving the property and adding amenities that will lead to more revenue is a great way to increase NOI.
- Dog parks and dog wash stations won’t cost residents extra but will attract tenants willing to pay more in rent for the amenities.
- Laundry facilities and on-site storage units are excellent improvements. Both can be added to the property and lead to additional streams of recurring revenue. Why send residents off-site to do their laundry? Take unused space and convert it to a laundry facility.
- For on-site storage, it can be as simple as finding unused space for constructing metal buildings on the property. Areas that are too small to build apartments or parking spaces are great sites for these.
Add More Units or Space
In the case of multifamily properties, you can often add more units. Adding more units means more apartments that residents can be renting and paying you for.
A property I once worked with had a whole building of two-bedroom two bath units that averaged 1800 square feet. There were no one-bedroom apartments, and many prospective renters were looking for something smaller. The two-bedroom units were going for $850 per month, and renters needed a cheaper option.
The solution was adding a wall between each half, putting in another door, and a kitchen in one of them. This allowed the property owner to go from 16 units that were renting for $850 per month to 32 smaller efficiencies renting for $600 per month.
Doing the math, that’s an extra $67,200 in rent per year. All from doing a relatively light construction job. Smart investors and property owners are always looking for clever ways to increase revenue like this.
Non-refundable Deposits and Fees
Instead of reviewing applications for free and spending staff payroll time, require a non-refundable application fee. There’s no “right” amount, but look in your area and see what other properties charge. For example, 20 applicants per month paying a $35 application fee is an extra $8,400 in revenue annually. This is coming in whether or not they end up signing a lease.
Pet fees (per pet) and reserved parking fees are another great source of revenue. Having exclusive covered or up-close parking can demand a monthly premium. Some properties charge pet rent, but this is quickly falling out of practice in favor of upfront pet fees.
3. Increasing NOI through Decreasing Expenses
On the flip side of increasing revenue streams, increasing NOI by decreasing property expenses is possible. Let’s focus on the most common practices to reduce expenses.
Cutting the Water Bill through High-Efficiency Systems
There is a whole niche within the investing community of experts who focus solely on this one thing. Finding ways to help your property reduce expenses through water savings.
How is this accomplished? Using high-efficiency water faucets, low-flow toilets, efficient showerheads, and aerators on building water mains. In combination, these upgrades have been shown to save as much as 40% on monthly water expenses. In some cases, even more on properties that are not operating efficiently.
LED Lightbulbs and Ratio Utility Billing System (RUBS)
Another large expense is electricity. Especially on all bills paid properties where residents are less thoughtful about turning off lights when not in use.
Spending the money upfront to retrofit a property with efficient lighting can save thousands of dollars per year.
For properties that are looking to pass the cost of utilities to the residents fairly, implementing a ratio utility billing system, or RUBS, is a great solution. Rather than installing expensive submeters, it allows property managers to allocate monthly expenses to tenants based on several factors. They are factoring in square footage, the number of occupants, and the number of bathrooms or fireplaces in the unit to determine what ratio of total property utilities each tenant will be billed for.
This is huge when looking to increase NOI on a property. It is one of the primary things savvy investors look to do when purchasing a value-add investment.
Bring in Experienced Management
The most powerful action that you can take to increase NOI on a property is bringing in experienced property management. Experienced property managers are experts at increasing NOI and maximizing return on investment with each action they take on-site. They will be implementing all of the tactics we’ve been discussing.
Often times the largest property expense will be payroll. A seasoned property manager will cut payroll expenses through more efficient operations and through implementing technology allowing leasing agents to be more productive.
By bringing in a skilled property manager and using what you have learned, you will be increasing the NOI on your next investment property in no time. Let us know what other investing terms you would like to know about, as we build out our real estate investing series.