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Calculate Net Operating Income Like an Expert

Published January 17, 2013 

In commercial finance, they say cash flow is king. But what exactly is cash flow in the eyes of a financier?

The net operating income is the dollar amount used to calculate repayment ability. This is the gross income less the normal operating expenses. What are normal operating expenses? Well, many times it is in a property owner’s best interest to report as much expense as possible in order to avoid tax liability. It is a good thing to pay the least amount of taxes possible—until it comes time for financing.

The most common expense reported as part of normal operations, which should not be used in a cash-flow calculation, is the capital improvements category. When a property owner reports a roof replacement as a maintenance and repair item instead of a capital improvement, they typically get to write off the entire expense from that year’s taxes instead of claiming depreciation over several years. However, finance professionals do not consider a roof replacement to be part of the normal ongoing operations. A roof can last 10, 20, or even 30 years. An expense that occurs once every 30 years is not part of ongoing maintenance. So in these cases, we typically require a letter from the property owner stating that the roof replacement was actually a capital improvement, and collect documentation to prove it to an underwriter.

If the roof replacement cost $50,000, we can usually add $50,000 to that year’s operating cash flow and consider it part of the net operating income. So if upon first glance a property appears to have no operating income, do not fret. This is very common and is usually pretty easy for us to overcome. Once we are able to see which expenses are occurring on an ongoing basis, we can better formulate how the property will perform and what kind of return it offers.

A myriad of expense categories might need to be analyzed this way. When considering commercial property for purchase, it is typical to use several years of cash-flow statements in the analysis. Abnormally large changes in an expense category are often an indication of miscategorized expenses. This is why looking carefully at historical trends is essential to the due-diligence process. Though it varies with each particular bank, a good guideline for underwriters is: “Investigate any expense item that has changed more than 5% from one year to the next.”

Interpreting financial data can be difficult at times, but with enough practice anyone can draw reasonable conclusions in their initial look at a potential investment opportunity.  Keep your eye on the prize, and you’ll be confident the next time you go into contract on an investment property.