Serious about a career in real estate private equity? If so, there are several key accounting terms that need to become instinctive. If you even have to think about the definition of these terms, you don’t know them well enough yet. The more natural these terms become, the more prepared you are to crush an interview and land that first real estate private equity job.
Net Operating Income
Net Operating Income (NOI) is the cash flow generated by a property. NOI does not include anything related to the financing structure of the property (e.g., interest expense), GAAP items (such as depreciation and amortization), or the tax liability of the owner (income tax, for example). It is the raw performance of the asset: income minus operating expenses. The concept is the same as EBITDA, but real estate firms tend to favor the term NOI over EBITDA.
NOI is the starting point for valuing a property and the investment returns it can generate. Remember, NOI divided by cap rate equals value. This “direct-cap” valuation methodology is especially important if your fund is focused on Core assets. If your firm invests in Opportunistic, Value-Add, or Core Plus assets, knowing the current NOI and accurately estimating the pro forma NOI is the whole point of your LBO model.
Depreciation (and amortization) are much more than simply numbers you add back to the net income in order to calculate NOI. There is a lot more information embedded in that simple number.
The definition of depreciation is the annual allocation of expense for a tangible capital asset divided over its useful life. (Now you remember why you decided not to be a CPA, don’t you?) GAAP (Generally Accepted Accounting Principles) and tax laws don’t allow you to expense 100% of capital expenditures for assets that have a useful life greater than a year (with some exceptions, not covered here). In general, if an asset has an expected useful life of 10 years (a parking lot, for example), then you can expense 1/10th of the cost each year for 10 years.
But there is still more to depreciation. If you look at the balance sheet, you will see the total depreciation that has been expensed for all of the assets on the balance sheet (“accumulated depreciation”). The accumulated depreciation will be deducted from the total fixed assets of the company, resulting in “Net Fixed Assets.”
Why does this matter? Real estate requires upkeep and various replacements. If the net fixed assets on a balance sheet are less than half of the total assets, the property may have deferred maintenance issues. As you build your LBO model, you may want to budget for significant capital expenditures. At a minimum, an inquiry with the seller’s broker may be warranted.
Amortization is the same concept as depreciation, but amortization is reserved for intangible assets. Real estate intangible assets could be leasing commissions, loan fees, or tenant improvement allowances, all of which GAAP requires to be expensed according to the term of the instrument associated with the expense. Put another way, if a lease has a five year term, the leasing commissions and/or tenant improvement allowances must be amortized over five years. A loan origination fee associated with a ten year loan will be amortized over ten years.
Any real estate private equity job is going to require you to have an instinctive understanding of accounting terms like NOI, depreciation and amortization. There are a host of other concepts that could be discussed that are useful to a career in real estate private equity. Until we write those posts, however, be sure to grow and sharpen your skills with courses from Leveraged Breakdowns!