You’ve hit on one of the classic conundrums in commercial real estate. Five investors could look at the same deal and come up with 5 different NOI’s, and they could ALL be right.
The key is in which NOI you want, which depends on whether you’re buying or selling.
If you’re selling, the Pro Forma method as described above is typical, designed to portray the property in it’s best light. Using the Gross Potential Income (GPI) less and arbitrary vacancy and collection loss (usually 5%-10%) gives a hypothetical best case revenue. This may or may not (usually not) reflect the current rent roll.
Expenses are often stated as a percentage of gross revenue depending on property type–which won’t be the actual expenses at all. More professional brokers (e.g. CCIM methodology), calculates expenses from actual past performance, adjusted for inflation, and “normalized” to exclude any of the current owner’s non-property specific expenses. This is closer to reality than pro forma, but the NOI is still inherently incorrect due to the revenue assumption. (Also, variable expenses are rarely adjusted from actual occupancy vs. “potential” occupancy, understating the expenses.)
But this does produce the best possible NOI for the property, and many investors (or brokers) don’t dig any further. If I’m a seller I’ll put it out like this every time. If the buyer asks for actual numbers, I’ll supply them, but they have to ask.
If you’re buying, then you want to know what the NOI will be in the first year you own the property. You can work with the pro forma numbers, but need to substitute the actual revenue from the current rent roll instead of GPI (there is no V&C loss because the revenue is actual cash received).
Be aware that the revenue may not jive with the current rent roll, especially if there is a long gap between the end of the reporting period (say year-end) and the review (say mid-year following). This can be cured with a trailing twelve statement the most recent 12 months of actual operating results. (Many owners us e Quick Books and this function is available int he software.) (also see my article “Financial Due Diligence” at http://www.creonline.com/due-diligence-financial-analysis.html )
Expenses are normalized (i.e. adjusted to reflect how you will operate the property, see below) from the most current statements (preferably derived from 2 years performance), verify the major expenses (e.g. utilities, insurance, property taxes, etc.). Deduct this from the actual revenue and you have the NOI known as the “going-in” projection of NOI. (Never deduct debt service, only operating expenses.)
This is the number I want to use for establishing the asking cap rate, and for my own valuation. (See my article “What’s it Worth” at http://www.creonline.com/cap-rate-formula.html) If you don’t use the current rent roll and actual expenses, you’re paying the seller for income that doesn’t currently exist, and that you must produce in the future.
The difference between investors is in how they operate the property (e.g. fee managed or self-managed; maintenance outsourced or owner-performed; with or without CapEx reserves) ) which affects the projected NOI. Note: for loan underwriting a management fee is always deducted, whether or not self-managed.
So your initial impression that there is a lot of wiggle room in calculating NOI is correct. The key is to start from the real numbers, and adjust the expenses for the way you will operate the property and structure the deal.
Now, have I put that in terms no one can understand?