In the Commercial Real Estate (CRE) space, there is a lot of focus on Net Operating Income (NOI) and rightfully so, since driving NOI drives value creation. But over the course of a deal’s life-cycle, NOI does not have a lot of meaning or value to investors. I know this might be a bold statement, but I will explain why in this article. Also, NOI can easily be manipulated by various accounting treatments. NOI does not provide a good measure of a property’s generated cash flow, which is one of the fundamental ‘benefits’ of investing in real estate.
In this article, I will explain why NOI is not very important during the deal life cycle and provide more meaningful metrics and financial statements that show a better picture of a property performance.
Net Operating Income (NOI)
To recap our previous discussions, Net Operating Income is calculated as follows:
A cap rate is then applied to the NOI to determine the value of a property. For example, if a property has a NOI of $500K and a cap rate of 6%, the value of the property is $8.3M. To get more understanding on cap rates please read the article Why Cap Rates Do Matter. NOI is shown on the Trailing 12-month (T12) P&L, which is the financial statement that most investors use to manage performance during acquisition and during the hold period.
If you think about the overall life-cycle of a deal, which is +/- 5 years for multifamily, NOI has very little impact or value during this duration. As stated above, NOI drives value.
When does value matter? Only when you have a capital event (i.e. buy, sell or refinance) or if you are the lender monitoring debt coverage.
How often does a capital event happen? Probably 3 times during a hold period (the buy, the refi and the sell).
So outside of those capital events, why is there focus on NOI? Sure, it gives you the starting point and a picture of where the property is trending operationally, but it does not take into account debt service, partnership-level expenses, capex, etc.
Many investors (sponsors and passives) place heavy emphasis on property performance by monitoring budget to actuals of NOI, but in reality this view is limited as there is a lot more to the financial story and property health ‘below the line.’
Net Income
Net Income is calculated by starting with NOI and adding / subtracting all all the ‘below the line’ items as shown below.
Net Income indicates the amount of profit after all non-operating income/expenses and provides a better picture of the profit generated by the entity. However, it still does not provide a clear picture of the true cash flow generated by the property. To understand the cash flow of a property, investors need to moved away from the P&L and review the Cash Flow Statement.
Operating Cash Flow (OCF)
Investopedia defines Operating Cash Flow (OCF) as “measure of the amount of cash generated by a company’s normal business operations. Operating cash flow indicates whether a company can generate sufficient positive cash flow to maintain and grow its operations, otherwise, it may require external financing for capital expansion.”
Operating cash flow is the first section presented on the Cash Flow Statement (CFS), which is one of the 3 main financial statements used by all companies; the others being the Balance Sheet and Profit and Loss (P&L). The CFS is the most complex financial statement to understand but it provides the best picture of the cash inflows and outflows of a company. The OCF starts with the net income and makes adjustments to remove the non-cash impacts to determine the true cash inflow generated by operations.
The OCF section on the CFS is critical in understanding the cash generated from primary operations. It removes the impact of how certain accounting treatments and management policies can skew the NOI or Net Income calculations on the P&L. It should be noted that various accounting treatments and classifications can have a huge impact on how the financial statements are interpreted. Some of these treatments include cash vs. accrual accounting, expense vs. capital, etc. We will discuss these topics in more detail in another article.
In assessing the performance of a property, sponsors must conduct operating cash flow analysis regularly and this is especially important before making investor distributions decisions. Sponsors can avoid surprises (e.g. not over distributing, anticipating capital needs, etc.) if they pay attention to operating cash flows as it provides a better barometer of the property’s health. Since cash flow is one of the most touted benefits of real-estate investing it makes sense to focus on the ‘Cash Flow’ Statement in addition to the P&L and Balance Sheet.
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