NOI vs Cash flow? How?

Question

OK just starting out here so excuse my ignorance, but how does NOI make any sense on its own? Shouldn't there be some type of relationship between NOI and Operating Cash Flow, like a rule of thumb such as "if OCF outweighs NOI by X amount, don't invest"

Example: $1,000 in rental income per month - $200 in expenses = $800 per month. NOI alone says Great Investment.

But if Mortgage Payment was $2,000 / month to generate the $800 above, isn't this a Horrible Investment?

I don't understand how it is so easy to justify these as two completely seperate indicators when one directly reduces the success of the other. Can someone please help me understand? It seems like Cash Flow should be the ONLY ratio that matters but I keep reading that NOI is actually the more important of the two.

Llewelyn A. · Answer

Let's say you have Property A and Property B. The dynamics are as follows:Property A- Purchase Price: $100,000- NOI: $10,000- Cap Rate = $10,000 / $100,000 = 10%- Debt Service: ZERO - You decided to buy this property without a Mortgage- Cash on Cash Return: $10,000 / $100,000 = 10%Property B- Purchase Price: $100,000- NOI: $10,000- Cap Rate = $10,000 / $100,000 = 10%- Debt Service: $375 per Month: $90k Mortgage at 5% Interest Only- Cash on Cash Return: ( NOI of $10k minus $375 per month x 12 ) / ( $100,000 purchase Price minus $90k Mortgage )- Cash on Cash Return = $5,500 / $10,000 = 55%So? What is a better property? Property A or Property B?If you decided to use the Cap Rate, they are both Equal.If you decided to use the Cash on Cash Return, Property B has a 55% CCR while Property A only has a 10% CCR. Does that really mean Property B is better because you used a 90% Mortgage versus no mortgage for Property A?Logically, it doesn't make sense to judge a property by the way you finance it. You judge it by a metric that take debt service out of the equation. That's why we use the Cap Rate.This is exactly why I have a saying......There is no such thing as an Investment that Cash Flows..... It's the INVESTOR that Cash Flows the property because he has control over the financing.To bring that saying home, consider Property C:Property C- Purchase Price: $100,000- NOI: $10,000- Cap Rate = $10,000 / $100,000 = 10%- Debt Service: $900 per Month: $90k Mortgage at 12% Interest Only- Cash on Cash Return: ( NOI of $10k minus $900 per month x 12 ) / ( $100,000 purchase Price minus $90k Mortgage )- Cash on Cash Return = NEGATIVE $800 / $10,000 = NEGATIVE 8%So now that same 10% Cap Rate Property is a Negative 8% CCRDoes that mean it's all of a sudden a bad property because it's a negative cash flowing property?I think this is enough Math to hammer home the concept of Cap Rate and why you should use it versus another metric that incorporates Debt Service.I'll leave it to the reader to absorb the above. Hopefully this helps.

Llewelyn A. · Answer

@Mike CampiCap Rate is just one of several criteria that you use in order to make a decision, but it is among the FIRST of the metrics.Probably the 2nd one to use is to determine what level of Cash Flow that makes sense to you PERSONALLY, not by some formula that others tell you that you should use.In my case, I don't need the cash flow since I have enough cash flow just by the other businesses that I own and the Real Estate Portfolio that I have. In fact, I can even go negative cash flow if I want without affecting my life style.Once I know what I can afford in terms of cash flow, I can then add another metric in to my decision criteria.Now I can look at Appreciation, both Rent and Price.Let's go back to the 3 scenarios, Property A, B and C.Property A is NYC, a highly rent appreciation city. The specific location had demonstrated that on average, the rents move up around 5% per year for the last 30 years.Property B is in a city that never really appreciates but has stable rents over the last 30 years.Property C is a Mobile Home. You will expect it to be completely destroyed over the next 30 years and become worthless.When you are looking into the analysis of these 3 kinds of properties for appreciation metrics, you can us a spreadsheet for Property A and it will look like this:Property B, no need to have a chart, you know that the rents will remain at $1,000 per month since it's in a stable rent area.Property C, you may have both decline rent along with the decline of the value of the mobile home.Now, taking this into consideration, even if I finance Property A so that I wind up losing Cash Flow in the 1st year by NEGATIVE $40 per month, by year 2018, I am now positive cash flow by $10. 2019, I am now $$63 in positive cash flow.For a Property like A, the increasing rental appreciation will make a negative cash flow eventually positive.Property B and C are not like that.The likely increase in Rent and Price Appreciation is exactly why Investors like myself are willing to forgo on the Cash Flow NOW. We know that it will come in the future.It's sort of like a job search.Do you take the Job that will increase your salary from $1k per month to $1,629 per month in the next 10 years but you have to start off at zero the first year because you are interning? This is similar to a Doctor going through residency where he doesn't make much money to survive on but after he graduates, his salary goes up and up.Or is it better to take a job where you get your monthly $1k per month forever but there is no internship?So you see, there are many choices. Unfortunately, those choices are generally unknown because the average Real Estate Investor doesn't educate themselves enough to know about the calculations needed to understand future value calculations. Therefore, they only have one thing in mind, just the cash flow Now calculations like CCR or GRM, etc.Sorry about the lengthy posting and I'm leaving out a lot. But I just wanted you to get the picture why there is a select few of us that will forgo on the Cash Flow Now and opt for a property that will give us future cash flow.

Jaysen Medhurst · Answer

@Mike Campi, NOI doesn't take into account financing, because people finance properties differently and having a common base line s important when assessing investments.While the example you cite is unrealistic (basically says a property worth $500k would only rent for $1000/month), it illustrates an important point. CF is only 1 part of the investment pie. Putting aside depreciation and mortgage pay down for a moment, if the property was appreciating in a very strong market, you could still be making out very well. The property only needs to appreciate at 3%/year (average) to break even.

Andrew Johnson · Answer

Mike Campi You have to look at both. However, your example is a little odd. A $2,000 mortgage payment is roughly debt service on $400K so you’re north of $500K on a purchase price. If you’re getting $1,000 gross rents on a $500K property something is really weird. Regardless, costs of capital can change from person-to-person even at a static moment in time. If I use a bank it’s different than it you use a HML. If I get a 25 year amortization and you get a 20 year amortization from your commercial lender, it’s different. But the property itself (if you’re using NOI as a proxy for value in a commercial property) doesn’t change in value based on my cost-of-capital vs. yours. It’s effectively “neutral” which matters if you’re trying to do an apples-to-apples analysis of investment options.

Charles Kennedy · Answer

Simply put, not every investor will utilize leverage the same way (or maybe at all!) so NOI is most important when multiple investors are looking at a property (i.e. CRE Brokers will always give you an NOI and cap rate, not cash flows). I look properties for my analysis based on cash flow, because I know how I plan to leverage it.

Mike Campi · Answer

@Llewelyn A. sorry - writing for clarity, i mean if you cannot finance on your terms, does that become the reason to execute vs not execute or do you still place a greater weight on your anticipated NOI when deciding to make a purchase

Mike Campi · Answer

@Llewelyn A. I understand why you're saying what you're saying. That said, let's take example B vs C though. Understood that the financing itself has NO bearing on the property or its ability to create value, but does your ability to finance then become your primary decision making tool? While the property's NOI is identical in B and C, B is a decision that economically rational people would take on, whereas C would not make logical sense (as far as I can tell, but again, no experience). Also wanted to thank you in advance , tremendously helpful and thoughtful. also wanted to also thank everyone for writing. happy that I joined BP. thank you all for your insight.

Brent Coombs · Answer

@Mike Campi, I agree, every investment decision MUST take into account its mortgage, so therefore, NOI by itself should NEVER be the deciding factor, but must be drilled down to expected cash flow - after ALL expenses. Welcome to BP...

Christopher Phillips · Answer

Mike Campi It’s different when reviewing commercial properties (NOI) instead of residential (cash flow).