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A positive approach to NOI.

General Motors announces it will close 20 factories and eliminate 74,000 jobs. United Technologies announces it will lay off 3,900 employees. Everywhere we turn, we see businesses taking steps to downsize. And, of course, the real estate industry has suffered as much as or more than other sectors of the economy.

One of my former students, Bill Root, property director for the southwestern region of Hall Financial Group, Dallas, recently pointed out that the difference between each year's Super Bowl champion and several almost-ran teams is a hair's breadth. The common thread among the champions is the ability to focus intently on what they must do to win and do it under intensely unfavorable conditions. Like those champions, the key to property management success in today's competitive real estate markets lies in our ability to focus on and execute our mission.

The manager's mission

This mission is to recapture as much of a property's eroded value as feasible while maintaining the highest possible cash flows.

The question becomes: How do we accomplish these goals? Our first inclination may be to emulate other businesses and focus on cutting costs. And why not? Our expenses can typically be controlled to a much greater extent than can our income. In addition, as property managers, our cost-control skills are typically more highly developed, as we have a natural tendency to focus on expenses.

But it is for just this reason we often cannot significantly impact our NOIs today through cost cutting. Because our industry has been experiencing a recessionary cycle since 1986, most of us have already cut costs stringently.

If we expect to improve our properties' NOI further, we must turn our sights to income generation, not to further cutbacks. We must concentrate our efforts on leasing and other revenuegenerating aspects of NOI. The following example illustrates the greater benefits derived by focusing on income.

A case in point

Figure 1 is a summary of the previous year's operating experience at a hypothetical residential property. For ease in illustration, let's assume this 250|unit property has $1,250,000 gross potential income (GPI) with a 20 percent vacancy/delinquency (also known as economic vacancy) factor, resulting in $1 million effective gross income (EGI).

Again for ease in illustration, group the expenses into the two most commonly used categories: capital expenses and operating expenses. Capital expenses are those expenses incurred for replacement of major building components. These expenses may not be fully deducted in the current tax year, but instead amortized over a period of years when determining taxable income.

Operating expenses are those expenses which are incurred in the ordinary conduct of business and are fully deductible in the current tax year.

We will further divide the operating expenses into the subcategories of controllable and uncontrollable expenses. As the name implies, controllable expenses are those which ownership/ management can directly control. Examples would be salaries, advertising costs, and plumbing supplies.

"Uncontrollable expenses" may be a misnomer. Typically, this category would include insurance costs, utilities, and real estate taxes. Of course, the presumption here is that ownership/ management cannot control or impact these costs. Certainly it is true that we have little or no impact in the establishment of the millage rate, the cost per gallon of water, or the establishment of rates in insurance markets. However, we can impact these costs by appealing assessed values aggressively, installing relatively simple energy-saving devices, and ensuring that the property is not overvalued for insurance purposes.

In my experience, if the property does not have attentive management, the biggest savings may typically be obtained in this supposedly uncontrollable expense area. However, for purposes of this illustration, we will assume that the manager has already taken steps to obtain savings in this area.

To cut or to grow?

Now, let's say that through extraordinarily clever management, we obtain a 10-percent savings over and above the already low outlays in the controllable expense area. The new position is illustrated in Figure 2.

Alternately, let's say that through establishing an intensive marketing plan, we are able to raise our occupancy by 25 apartments. Though that figure is 10 percent of this property's total units, at an average rent of $417, it represents only 0.8 percent in a market of 3,000 units. The outcome of this strategy is illustrated in Figure 3.

Now let's compare the results. Our careful stewardship of expenses results in a $35,000 increase in NOI and cash flow. This increase equates to a 350percent improvement in cash flow and a 7-percent improvement in NOI. Assuming a 10-percent capitalization rate, value would be increased by $350,000 (NO1 + cap rate). Impressive.

However, increasing occupancy by 25 units creates a $100,000 increase in NOI and cash flow. That equates to a whopping 1,000 percent improvement in cash flow, as well as an increase of $1 million (20 percent) in the property's value assuming the same 10-percent cap rate. That's the sort of results that leaves a lasting impression on ownership.

How did we get such a significant difference in income and subsequent value when we improved each area by the same 10 percent? The answer is simple, but too often overlooked. When we make income generation our primary mission, we are impacting "top line" dollars. When we make expense reduction our primary mission, we impact only a portion of our "top line" dollars: 50 percent at best. The rest goes to pay our uncontrollable expenses and debt service. Income generation beats cost cutting every time.

A final note

For the sake of simplicity, we have used the example of a residential property. Those who own or manage office or retail space will immediately notice that capital expenses remained static in the illustration. Because we almost always incur costs for tenant improvements and leasing commissions when leasing office or retail space, the properry's cash flow may decline during lease-up.

However, by far the largest portion of the owner's return on and of a typical real estate investment is the net sales price. That sales price is based, in large part, on the property's NOI. And the NOI would increase in exactly the same manner as it did in the illustration of the residential property.

Think again of Bill Root's remark, that the difference between each year's Super Bowl champion and the division winners is a hair's breadth created by the ability to focus intently on what they must do to win. By focusing on and executing leasing plans to increase income in today's difficult real estate markets, we place ourselves and our owners in the position to be winners.

John A. Warthman, CPM(TR), is the principal of Southeastern Asset Management, Inc. The company offers consulting and management services to owners of apartments and business parks. Mr. Warthman previously served as senior vice president for a full-service real estate firm, where he specialized in receivership work as well as rehabilitation and subsequent sale of REO properties for numerous financial institutions.
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Title Annotation:net operating income
Author:Warthman, John A.
Publication:Journal of Property Management
Date:Mar 1, 1992
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