Noi real estate case11/13/2023 Let’s assume that we’re going to use a 7% market capitalization rate and apply it to the NOI. The formula is familiar to most investors: Why do we care about the NOI at all? One reason is that it is common to apply a capitalization rate to the NOI in order to estimate the property’s value at a given point in time. Funds placed in reserve are not money spent, but rather funds taken out of one pocket and put into another. Perhaps even more telling is the fact that we expect the money spent on an expense to leave our possession and be delivered to a third party who is providing some product or service. Reserves don’t fit that description, and in fact would not be treated as a deductible expense on your taxes. Operating expenses are costs incurred in the day-to-day operation of a property, costs such as property taxes, insurance, and maintenance. First, NOI by definition is equal to revenue minus operating expenses, and it would be a stretch to classify reserves as an operating expense. This makes sense, I believe, for a number of reasons. That approach, which you will find in most real estate finance texts ( including mine), in the CCIM courses on commercial real estate, and in our Real Estate Investment Analysis software, is to put the reserves below the NOI – in other words, not to treat reserves as having any effect on the Net Operating Income. There is, for want of a better term, a standard approach to the handling capital reserves, although it may not be the preferred choice in every situation. Notice that the cash flow stays the same because the reserves are above the cash flow line in both cases. Clearly, the NOI is lower in the second case because we are subtracting an extra item. Now let’s move the reserves above the NOI line. This apparently simple concept gets tricky when we raise the question, “Where do we put these reserves in our property’s financial analysis?” More specifically, should these reserves be a part of the Net Operating Income calculation, or do they belong below the NOI line? Let’s take a look at examples of these two scenarios. Where do “Reserves for Replacement” Fit into Your Property Analysis? Such an account may go by a variety of names, the most common being “reserves for replacement,” “funded reserves,” or “capex (i.e., capital expenditures) reserves.” Also, a lender may require the buyer of a property to fund a reserve account at the time of acquisition, particularly if there is an obvious need for capital improvements in the near future. That investor may plan to move a certain amount of the property’s cash flow into a reserve account each year. The question is simply when, not if, these and similar items will wear out.Ī prudent investor may wish to put money away for the eventual rainy day (again, the roof comes to mind) when he or she will have to incur a significant capital expense. Think HVAC system, roof, paving, elevator, etc. While that observation may seem to be better suited to a discourse in philosophy, it also has practical application in regard to your property. It may sound like a nit-picking detail: Where and how do you account for “reserves for replacement” when you try to value – and evaluate – a potential income-property investment? Isn’t this something your accountant sorts out when it’s time to do your tax return? Not really, and how you choose to handle it may have a meaningful impact on your investment decision-making process.
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