incremental net operating income
Welcome to solsarin, In this article, we answer “incremental net operating income”.
We then describe how to calculate net income and NOI using the net income formula. Equally important, we show how to calculate net income from a balance sheet and from an income statement. Additionally, we see how the real estate income statement is specialized to report information related to rental properties. Finally, we review a helpful example of NOI and answer some frequently asked questions.
The task of making a profit from a real estate investment rests on the ability to earn more than you spend. Two key terms we use to analyze revenues and expenses are net income and net operating income (NOI). While both are indicators of profit and loss, NOI comprehends only your operational efficiency. On the other hand, net income incorporates all factors that contribute to a profit. Truthfully, both are essential elements for reporting and managing the financial condition of a real estate project.
What is Net Income and NOI?
Let’s look at the characteristics of both terms before we discuss how to calculate net income and NOI.
Characteristics of Net Operating Income
In the context of real estate, NOI represents how well you operate your properties. In other words, it shows you whether you collect enough revenues to pay for all necessary operational expenses. Specifically, property revenues include rents, as well as various fees for maintenance, servicing, parking, and so forth. Normally, you exclude property sale gains (and losses) from NOI because they are usually singular, non-recurring events. However, if you operate a fix-and-flip business, you should include gains and losses in NOI.
Operational Expenses
There can be numerous operation expenses relevant to NOI in commercial real estate. For example, these include:
- Maintenance costs (indoor and outdoor, including snow removal)
- Fees paid to a property management company
- Property taxes
- Janitorial fees
- Insurance
- Utilities
- Supplies
- Other expenses
However, NOI ignores specific expenditures:
- Interest: You want to analyze a property’s operations independently of its capital structure. That is, the relative amounts of debt and equity shouldn’t affect the operation of the property. Rather, you can decide how much debt to take on separately from how you operate your properties.
- Income Taxes: Your income tax bill relates to your net income rather than your NOI.
- Depreciation and Amortization: These are non-cash expenses that you accumulate on a balance sheet. These items are essential for income tax preparation and reporting. In fact, they are not real-world expenses. In addition, properties typically appreciate over time, making amortization and depreciation less meaningful.
- Capital Expenditures: These create assets that reside on the balance sheet rather than as expenses on the income statement.
- Company Overhead: These are expenses arising from the company that owns the properties. Similarly, it includes indirect labor costs for accounting, legal, marketing and other functions. Additionally, it covers items like office supplies, data processing costs, and so forth.
- Management Incentives: Properties, like hotels, might provide bonuses to hotel managers who perform well. However, you’ll exclude these costs from NOI.
You will sometimes encounter the term EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization. Obviously, it is like NOI, except that we use EBITDA when measuring the performance of companies rather than properties.
Characteristics of Net Income
Net income encompasses all revenues and expenses, not just operational ones. That is, it includes all the revenues and expenses that we excluded from NOI. We also call it net income, profit, or the bottom line. At the end of the reporting period, you add net income to (or subtract the net loss from) retained earnings. The balance sheet reports retained earnings, which owners can use to draw funds from the business.
How to Calculate Net Income and NOI
It will help to understand how to calculate net income and NOI by discussing the income statement for properties. Real estate income statements are somewhat specialized to reflect the industry’s workings.
How to Calculate NOI
The components of the NOI calculation are:
- Rental Income: This is the potential rental income you would earn with no vacancies and all units making timely payments.
- Gains or Losses to Lease: This represents any differences after an initial lease expires. Henceforth, it simulates renewals or new tenants with rents above or below the previous rental income.
- Gross Potential Income: This equals the potential rental income adjusted by gains or losses to lease.
- Vacancies: The potential revenue lost due to vacancies.
- Concessions: The potential revenue lost due to concessions such as a free month of rent and/or parking.
- Delinquency/Credit Loss/Bad Debt: Losses due to an inability to collect the full rent.
- Total Rental Income: This equals gross potential income minus vacancies, concessions, and delinquency/credit loss/bad debt. In other words, it is the cash you actually collect from tenants.
- Other Income: Non-rental income from various sources, such as laundry, parking, and late fees.
- Total Income: Equal to total rental income plus other income.
- Variable Operating Expenses: For example, these include direct labor, utilities, supplies, pest control, and other variable costs directly tied to operations.
- Fixed Operating Expenses: For example, these include property tax, insurance and management fees.
- Total Operating Expenses: The sum of variable and fixed operating expenses.
- Net Operating Expenses: Total income minus total operating expenses.
Net Operating Profit After Tax (NOPAT)
What Is Net Operating Profit After Tax?
Net operating profit after tax (NOPAT) is a financial measure that shows how well a company performed through its core operations, net of taxes. NOPAT is frequently used in economic value added (EVA) calculations and is a more accurate look at operating efficiency for leveraged companies. NOPAT does not include the tax savings many companies get because of existing debt.
Understanding Net Operating Profit After Tax (NOPAT)
Net operating profit after tax (NOPAT) is a company’s potential cash earnings if its capitalization were unleveraged — that is, if it had no debt. The figure doesn’t include one-time losses or charges; these don’t provide a true representation of a company’s true profitability. Some of these charges may include charges relating to a merger or acquisition, which, if considered, don’t necessarily show an accurate picture of the company’s operations even though they may affect the company’s bottom line that year.
Analysts look at many different measures of performance when assessing a company as an investment. The most commonly used measures of performance are sales and net income growth. Sales provide a top-line measure of performance, but they do not speak to operating efficiency. Net income includes operating expenses but also includes tax savings from debt. Net operating profit after tax is a hybrid calculation that allows analysts to compare company performance without the influence of leverage. In this way, it is a more accurate measure of pure operating efficiency.
To calculate NOPAT, the operating income, also known as the operating profit, must be determined. It includes gross profits less operating expenses, which are comprised of selling, general, and administrative (e.g., office supplies) expenses. The NOPAT formula is
NOPAT=Operating Income×(1−Tax Rate)where:Operating Income=Gross profits less operating expenses\begin{aligned} &\text{NOPAT} = \text{Operating Income} \times \left ( 1 – \text{Tax Rate} \right ) \\ &\textbf{where:} \\ &\text{Operating Income} = \text{Gross profits less operating expenses} \\ \end{aligned}
NOPAT Example
For example, if EBIT is $10,000 and the tax rate is 30%, the net operating profit after tax is 0.7, which equals $7,000 (calculation: $10,000 x (1 – 0.3)). This is an approximation of after-tax cash flows without the tax advantage of debt. Note that if a company does not have debt, net operating profit after tax is the same as net income after tax. When calculating net operating profit after tax, analysts like to compare against similar companies in the same industry, because some industries have higher or lower costs than others.
Special Considerations
In addition to providing analysts with a measure of core operating efficiency without the influence of debt, mergers, and acquisitions analysts use net operating profit after tax. They use this to calculate free cash flow to the firm (FCFF), which equals net operating profit after tax, minus changes in working capital. They also use it in the calculation of economic free cash flow to the firm (FCFF), which equals net operating profit after tax minus capital. Both are primarily used by analysts looking for acquisition targets since the acquirer’s financing will replace the current financing arrangement. Another way to calculate net operating profit after tax is net income plus net after-tax interest expense (or net income plus net interest expense) multiplied by 1, minus the tax rate.
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EX-99 15 dex99.htm ONE-YEAR RETURN ON INCREMENTAL INVESTED CAPITAL (ROI)
Exhibit 99. McDonald’s Corporation One-year Return on Incremental Invested Capital (ROI)
Return on incremental invested capital (ROI) is a measure reviewed by management to determine the effectiveness of capital deployed. One-year ROIIC is calculated as a percentage. The numerator is the Company’s constant rate (constant rate excludes the impact of foreign currency translation) incremental operating income plus depreciation and amortization, based on a comparison of the current and prior year periods. The denominator is the constant rate weighted average adjusted cash used for investing activities during the two-year period. Adjusted cash used for investing activities is defined as cash used for investing activities less net cash (collections) and issuances of notes receivable, which do not generate operating income. Constant rate weighted average adjusted cash used for investing activities is based on a weighting applied on a quarterly basis detailed in the following table.
