The next step is to subtract from gross effective income all operating expenses to calculate the NOI. Operating expenses include items such as real estate taxes, payroll, utilities, repairs and maintenance, management and other expenses. An abbreviated calculation would be:
- Gross potential income $450,000
- Less vacancy and credit loss $90,000
- Gross effective income $360,000
- Less operating expenses $180,000
- Net operating income $180,000
For the purpose of example, let’s assume the buyer, seller and lender all agree the annual NOI of a property is $180,000, and the appropriate capitalization rate is 9 percent. (By the way, lenders often include items such as reserves, management fees, etc., that owners don’t always consider when calculating NOI.) We can determine value by a simple formula: Income divided by capitalization rate equals value.
Calculating value•IRV = income / cap rate x value•NOI = $180,000•cap rate = 9%•value = $2,000,000
Therefore, a self-storage property with an NOI of $180,000 will have a value of $2 million at a 9 percent cap rate based on a snapshot in time.
The capitalization rate method is based on a short period of time, usually 12 months or less, and is, therefore, a snapshot. It does not take into consideration the value of a property owned over a longer period. Accordingly, another method to determine value is one that evaluates revenue and costs a property will generate over time of ownership, including the proceeds from a sale.
This holding period method uses a measurement entitled internal rate of return (IRR), which is defined as the rate of return on each dollar that remains in an investment. It is a methodology that considers the purchase price of a property, the NOI of the property over the holding period, and the sale proceeds generated from the property at the end of that period.