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Investors buy income producing properties for the cash flow. Whether they are Office, Retail, Industrial, or Multifamily properties, virtually all of the income is derived from leases. In commercial real estate, there is no such thing as a standard lease and all leases are unique. The clauses used in a lease can have a large impact on the value of a property. Many volumes of books have been written on lease clauses, so I will have to save that topic for a later date.
The leases for income producing properties generally outline the contractual terms for:
Rents to be received
Term of the lease
Expensed to be paid, either by Landlord or Tenant
Other economic and non-economic terms
Upon examining the leases for an income producing property we should be able to clearly determine the total rents to be received as well as any expenses that will be paid by the landlord and tenants. A quick look at the building's income and expense statement should provide the necessary dollar figures to compute net operating income. Essentially, net operating income, or NOI, is the total income received minus the expenses the landlord is responsible for. NOI does not include any income received from the sale of a property, only the annual rental income and expenses. NOI is a very important figure in determining the value of a property, that is, what another investor may be willing to pay for the property.
Basically, rent minus landlord-paid operating expenses equals Net Operating Income. Many investors look at NOI as a return on their investment. For instance, if a building priced at $100,000 has an annual NOI of $16,000, then the annual return on investment is 16%. This percentage return on investment is referred to as the capitalization rate, or cap rate, as is a great way to compare different real estate investments. By determining a potential investment property's cap rate, an investor can compare several different properties to one another as well as other investment vehicles such as stocks and bonds.
Although cap rates are a great way to compare properties, keep in mind that they are only a one year "snapshot" of the relationship between income and value. Cap rates do not consider future income and for that we will need to calculate the "net present value" of a property, which will be covered in a later blog.