What is Forward NOI?
The Forward NOI is a pro forma projection of a rental property’s net operating income (NOI) using various operating drivers, such as occupancy and vacancy rates.
How to Calculate Forward NOI
The forward NOI is frequently used in the commercial real estate market to estimate the net operating income (NOI) of a rental property in the future, most often on a twelve-month basis.
The net operating income (NOI) of a property is calculated as the total profits generated by a property via the collection of rent from tenants and other sources of income, minus operating expenses incurred as part of running the property (e.g. property management fees, property taxes, utilities).
One critical concept to understand regarding net operating income (NOI) is that the metric does not include principal amortization, interest payments, or capital improvements.
The forward NOI is therefore considered an unlevered metric, as the effects of discretionary decisions by management, such as those related to financing, are not part of the calculation.
Calculating the forward net operating income (NOI) is a three-step process:
- Project Property Rental Income → The total rental income projection represents the proceeds earned if all units in the property were rented at the market rate. The calculation must consider potential changes in market conditions and rental rates, as well as any other sources of income, such as fees collected for laundry services or parking.
- Project Vacancy and Credit Losses → The vacancy losses refer to the rental income lost from unoccupied units (i.e. no tenants), whereas credit losses stem from tenants that refuse to pay rent or are incapable of meeting rent obligations on time.
- Project Operating Expenses → Operating expenses, compared to rental income and vacancy (and credit) losses, are far easier to predict, although there are certainly scenarios when there can be substantial variances. But for the most part, the operating expenses are the costs incurred from running the day-to-day operations of the property, including property management fees, insurance, taxes, maintenance, and utilities.
What is a Good Forward NOI?
In order to accurately project a property’s forward NOI, an investor must spend enough time researching the underlying drivers of performance. The common operating drivers of revenue for property investments include rental pricing rates, vacancy rates, potential sources of income, and recurring operating expenses.
The accuracy of such estimates will depend on the quality of the investor’s discretionary assumptions, which were integrated into the model (i.e. “garbage in, “garbage out”).
The forward NOI is a crucial input in numerous real estate valuation models, such as the direct capitalization method, in which the NOI is divided by the capitalization rate (“cap rate”) to estimate the value of a property.
Per usual, the forward NOI is a pro forma metric that can be unexpectedly influenced by external factors, such as sudden changes in the economy or market conditions.
Therefore, investors should ensure their portfolios are sufficiently diversified, and measures are put in place to mitigate risk (and avoid the potential loss of capital).
Forward NOI Formula
The formula to calculate the forward NOI of a property is as follows.
Where:
- Projected Rental Income → The estimate of the total income a property could generate from rental and other auxiliary sources, such as amenities, laundry services, vending machines, and parking fees.
- Projected Vacancy and Credit Losses → The losses expected to be incurred from unoccupied units (i.e. vacancies) or tenants unable to meet their rental payments in full (i.e. credit losses).
- Projected Operating Expenses → The costs necessary to be paid to continue operating and to maintain the property, including property management fees, insurance, taxes, maintenance, and utilities.
This provides an estimate of the property’s net income, looking forward to the future. It’s important to keep in mind that these are estimates, and actual results could be different due to unforeseen changes in market conditions, unexpected expenses, or variability in income. As such, investors and analysts often use multiple scenarios (e.g., best-case, base-case, worst-case) to evaluate a range of possible outcomes.
The forward NOI does, in fact, attempt to be a comprehensive metric that accounts for all future sources of income and expenses, yet there are far too many unpredictable variables that cause such efforts to be futile.
Therefore, the limitations of forward NOI – a metric that cannot be calculated without simplification – must be understood to avoid the risk of mistaken interpretations that lead to poor financial decisions.
The use of any projection model is driven by assumptions regarding the future state of the market, the global economy, and consumer behavior, among various other factors.
Because of the forward-looking nature of such calculations, the uncertainties that these projections carry must not only be grasped, but there should be contingency plans prepared in case the downside case were to occur.
In short, it is critical to consider a wide range of potential outcomes and perform scenario analysis for investment decision-making.
