should a ffe annual reserve be deducted from N.O.I for determination of a cap rate?

In Selling Property - Asked by Tom G. - Jun 15, 2012
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Dawn S.
Spring, TX

To better assist the less experienced Commercial Real Estate Investors, I have provided this section which presents various factors and general calculations used to estimate Net Operating Income (NOI).
The general formula for calculating NOI follows:
Potential Rental Income - Vacancy and Credit Losses = Effective Rental Income
Effective Rental Income + Other Income = Gross Operating Income
Gross Operating Income - Operating Expenses = Net Operating Income
Income Levels
A commercial real estate property typically has four levels of income:
•Potential Gross/Rental Income (PGI/PRI)
•Effective Gross/Rental Income (EGI/ERI)
•Gross Operating Income (GOI)
•Net Operating Income (NOI)
Potential Gross/Rental Income
Simply, Potential Gross Income (PGI/PRI) is the total rental income a property could produce if it were 100 percent occupied and rented. In commercial properties, market rent is expressed as dollars per square foot (psf), usually per year. Apartment income is typically expressed as dollars per month per apartment unit.
Effective Rental Income
In multi-tenant properties, PRI is almost never achieved because most buildings are not fully occupied at any one time and vacancies change during the course of the year. A deduction is made from PRI to account for lost income due to vacancy. Not all tenants pay their rent on time and sometimes not at all. A further deduction is made for credit losses.
Vacancy and credit loss variables include:
•Quality of management
•Type of tenant
•Length of lease
•Tenant Turnover Rate
•Rental Rates
The dollar amount of vacancy and credit losses generally is estimated as a percentage of PRI. That resulting income is often referred to as Effective Rental Income.
Gross Operating Income
Investment real estate may provide additional revenue from other services available at the property. Additional income may be generated by:
•Coin laundry units on the property
•Vending machines
•Parking facilities
•Cable services
•Rental of roof space for satellite or high tech installations
•Business service centers
•Billable repairs
•Storage space rental
When this other income is added to Effective Rental Income (ERI), the result is Gross Operating Income (GOI).
Net Operating Income
Net Operating Income (NOI) is the income that the property will produce when all expenses required to operate the property are deducted from the GOI of the property. Operating expenses are the total cash outlays necessary to operate the property. Financing is not included in NOI because the level of debt is a choice of the investor.
NOI is a key value throughout all phases of Commercial Real Estate ownership. At acquisition it is used to determine a purchase price and to determine the amount of debt services available to the buyer.
Debt service and tax liability on the property are paid from NOI, leaving a balance that provides the return on equity investment. At the time of sale, NOI is important in determining the sale price at the end of the holding period.
Using Net Operating Income to Establish a Purchase Price
Many investors and appraisers use a cap rate to determine the value of a property. The cap rate is the ratio between the purchase price and the NOI of the property. It can be derived from the market by identifying comparable transactions or from market data sources.
The value of a property is determined by dividing the NOI by the cap rate, which results in the value of the property.
Value = NOI/Cap Rate
Determining the Cap Rate
When the purchase price and the NOI are known, the Cap Rate can be determined by using the formula below.
CR = NOI/Value
Pros and Cons of the Using Cap Rate
Pros - A principal advantage of using a Cap Rate is its simplicity of calculation.
It also accounts for:
•Any vacancy and credit losses
•Any operating expenses
Cons - Its simplicity also limits its reliability because the Cap Rate does not take into consideration:
•Any tax impact
Cap Rate only looks at a one-year forecast when determining value or measuring performance.
Annual Debt Service
Annual debt service (ADS) is deducted from NOI to determine the Before Tax Cash flow. ADS includes both principal reduction and interest payment.
Net Operating Income - Annual Debt Service = Before Tax Cash Flow
Before Tax Cash Flow - Tax Liability = After Tax Cash Flow
Before Tax Cash Flow
This is the amount of money the investor receives from the property after ADS is paid.

Jun 18, 2012
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Ned P.
Bonita Springs, FL

What type of property are you dealing with?

Jun 18, 2012
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Tom G.
Property/Asset Manager
Minneapolis, MN


Jun 18, 2012
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Rob B.
Chandler, AZ

No, it is normally a below the line entry.
Rob Baird

Jun 19, 2012
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Chris S.
Coeur D'alene, ID

What do your comparable cap rate sales tell you? If all of your sales have a reserve deducted then YES, if they do not then NO. Biggest issue that I see is that everyone needs to apply the same definition and derivation of cap rate.

Aug 1, 2012
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Robert H.
Corporate Investor
Orange, CA

Yes, my most recent appraisal for a hotel... Reserves were deducted from N.O.I... Don't listen to brokers, they typically know the least... This is just an FYI for the next person to Google this question.
See Reference for an expert in the field.

Feb 27, 2014
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