Discounted Future Net Operating Income

Valuation analysis

Discounted future net operating income (FNOI) is a financial metric used to assess the present value of future net operating income, while taking into consideration the time value of money.

Metrics

Discounted FNOI

Discounted present day value

What is Discounted FNOI

When assessing the value of anything it is important to consider the time value of money; this means that money today is worth more than same amount in the future because if invested today it will be worth more in the future.

This is important because if we assume an investment today into a property we want to see how the return in the future compares to an alternative less risky investment like a 10 year bond which would return an almost risk free rate.

Because we consider investing in property carries some risk we want to ensure that our return factors in that risk.

Important considerations

There are some important considerations that need to be thought about when looking at this metric.

Incomplete NOI
It is very difficult to predict all costs involved in managing a property so the Discounted FNOI calculation will almost always appear higher than reality.
Doesn't account for financing costs
Unless you are able to purchase the property outright there will be significant interest costs which will vary over the life of the loan. These are not accounted for and will have a big impact on the long-term returns.
Difference in risk tolerance
Every individual has a different risk tolerance so their required rate of return will be different which would impact the calculation result.
Changing risk-free rate
The risk-free rate is always changing so the required rate of return would also be impacted.

Calculating Discounted FNOI

The formula for Discounted FNOI involves using the Net Operating Income (NOI) for each future period and applying a discount rate.

Since we can't predict all the future income and we assume that the rental income for our property will increase overtime; we implement an average year-on-year growth rate.

Let's start with calculating the NOI, here is an example:

Gabrielle purchased an investment property for $600,000
The property has the following income and costs:
- Rent: $650/week
- Property management fees: 7%
- Rates: $700
- Land taxes: $950
- Body corporate: $1,650

Formula

(rent * (1 - managementFees) * 52) - (landTaxes + bodyCorporate + rates) = NOI($650 * (1 - 0.07) * 52) - ($950 + $1,650 + $700)$31,434 - $3,300 = $28,134Gabrielle's property has an annual NOI of $28,134

Now let's add a few more details and calculate the Discounted FNOI:

We are interested in value over 10 years
The risk free rate in Australia is 4.25%
The risk premium for property in Australia is 2%
Rent has grown by 4.1% on average

Formula

NOI / ((riskFreeRate + riskPremium) - growthRate)$28,134 / ((0.0425 + 0.02) - 0.041)$28,134 / 0.0215 = $1,308,558Gabrielle's investment will gross $1,308,558 over 10 years

It is important to remember that this doesn't account for many other operating costs and the cost of interest for financing this purchase.

This is however still a useful tool in assessing the present day value of an investment.