Net operating income (NOI) is one indicator used to determine whether a subject property will make a good investment. By measuring the ongoing operating costs of a property, real estate investors can use NOI to analyze how much revenue can potentially be generated from a given deal. For that matter, every investor stands to benefit from knowing how to evaluate the profitability of investment opportunities, and NOI real estate formulas are one of today’s best tools for doing so.
NOI can be a valuable standard for comparing potential deals or evaluating an existing property when calculated correctly. Keep reading to learn how a net operating income real estate analysis can help you measure your next deal’s potential.
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What Is NOI In Real Estate?
NOI in real estate is one of several metrics used by investors to determine how profitable a property is. Most frequently, net operating income is a benchmark used by investors to determine the cash flow and profitability of a potential deal or income-generating property. NOI is a strong indicator of a property’s ongoing revenue, though it does not account for capital expenditures, taxes, or interest payments. Instead, NOI is used to determine how profitable a property is on its own.
By using NOI to evaluate a deal, real estate investors can get a better look at the potential profitability of a property in relation to how much it would cost to operate it. NOI is typically calculated annually; although, investors can easily adapt the operating costs by dividing expenses by twelve. By excluding financial factors such as mortgage interest and taxes, NOI provides a specific look at the income a property can generate on its own. Thus, NOI is thought to be less subject to manipulation compared to other real estate calculations.
The only challenge in predicting NOI is that the potential income will depend entirely on how the property is being operated. Therefore, investors should be careful to use market factors as a reference when estimating potential rental income.
Why Is NOI Important for Real Estate Investors?
NOI is an important formula for real estate investors for two key reasons. First, investors almost always use NOI is a method for estimating the value of an investment project. For instance, they can find the potential value of a property by dividing NOI by the capitalization rate.
The second key reason NOI is important for real estate investors is that it is a metric used by commercial lenders to determine their willingness to fund a project. They will add NOI to taxes and interest expense to calculate EBIT, which is the amount a property can generate before interest and taxes.
Net Operating Income Formula
Income Generated From Property – Operating Expenses = NOI
However, please keep in mind that the aforementioned net operating income formula is one of many that may be used. Calculating the MOI in real estate deals can vary widely, depending on the individual making the calculation.
How To Calculate Net Operating Income
NOI for real estate is calculated using the total income generated from a property and subtracting the operating expenses. Start by calculating the gross operating income, which refers to the total rental income generated by the property. You can determine gross operating income by adding the total amount the property would generate in rent each month, then subtracting the amount lost from potential vacancies.
Once you have the gross operating income, add up any other revenue-generating items on the prospective property. This includes parking, laundry, vending machines, and any other service fees associated with renting the units. Finally, combine the gross operating income with any additional rental income before moving on to the next part of the formula.
Next, combine the operating costs of the subject property. Operating costs refer to any costs associated with running and maintaining the property on a given basis. These will include insurance costs, utilities, property management fees, property taxes, and repair costs.
Net Operating Income Example
For example, if the gross operating income was $10,000 and it generated an additional $2,000 in miscellaneous income, the total income would be about $12,000. If the operating expenses are around $4,000, the net operating income would be about $8,000. On the other hand, if there were multiple vacancies and the total income was only around $4,000 while the fees were $10,000, the NOI would be -$6,000. In cases where the expenses total more than the income generated, it would be called a net operating loss (NOL).
NOI & Cap Rate
The net operating income formula is specifically designed to help investors calculate the profitability of an income generating asset, not unlike a rental property. Done correctly, real estate NOI will represent all of an asset’s revenue minus every single operating expense. However, it is worth noting that an asset’s net operating income can do more than determine its revenue potential; it can help investors determine another important variable: capitalization rate (cap rate). The cap rate of a subject property will simultaneously place an objective value on the home and make it possible for them to compare dissimilar assets. A property’s capitalization rate is expressed as a percentage. Therefore, it can be used to compare otherwise different assets, which comes in particularly handy when deciding whether to flip a home or rent it out.
What Expenses Are Included In NOI?
The key to understanding the NOI real estate term is knowing which expenses are included and not. As a general rule, operating expenses should refer to any day-to-day costs associated with running the property. The following is a list of examples:
Property Management Fees: Property management fees are incurred by investors who choose to invest more passively. Landlords may remove themselves from the equation for a small percentage of the rent collected from a subject property. Nonetheless, transitioning to a primarily passive exit strategy will come at a cost that must be factored into the NOI.
General Maintenance: Every rental property, especially older ones, will require at least some degree of maintenance. Whether it’s groundskeeping, plumbing, or electrical work, any maintenance conducted on the subject property must be accounted for in its NOI.
Legal Fees: Whether ownership of a subject property leads to litigation or a landlord hires an attorney to draft a lease, the money spent on legal fees is no different from any other expense. Likewise, legal fees are an important variable in a traditional net operating income formula.
Utilities Not Paid By Tenants: In the event the owner elects to pay some or all of the utilities, their expense will impact the real estate NOI. For example, any sewage or waste fees paid by the landlord must be deducted from the income generated to identify the property’s NOI.
Property Taxes: Property taxes will vary from municipality to municipality, but they are nonetheless an important variable to factor into the NOI of a rental property.
- Insurance Costs: Money spent on insurance to cover the subject property must be included in the NOI, even if it’s only incurred once a year or biannually.
Is Mortgage Included In NOI?
Mortgage payments are not included in the net operating income formula for one simple reason: mortgage payments are not considered an operating expense. Again, as its name suggests, net operating income accounts for an asset’s total income and subtracts vacancies and operating expenses. Therefore, mortgage payments are not included in the formula. Instead, real estate NOI equations will take the ongoing costs required to run the property into consideration.
What Expenses Are Not Included In NOI?
When determining the net operating income, it is important to differentiate between costs that are unique to the property itself and costs that are specific to the investor. For example, when it comes to NOI, mortgage interest expenses will not be factored in. Here are other costs that would not be included when calculating net operating income:
Mortgage Interest
Income Taxes
Leasing Commissions
Debt Service
Property Depreciation
Tenant Improvements
Capital Expenditures
Repair For Wear And Tear
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When To Use NOI In Real Estate
Net operating income is primarily used when determining profitability for commercial or residential rental property real estate investments. When considering potential deals, NOI can be utilized by both investors and lenders. By looking at this indicator, lenders can judge whether or not investors will make enough cash flow to make loan payments. It is not uncommon for NOI to be used when approving commercial loans for real estate investors. This is because lenders want to know whether or not investors will pay back the loan when considering the potential cash flow.
While NOI is thought to be a reliable indicator when determining the potential income of a property, it is not the only real estate calculation investors should keep handy. Investors should familiarize themselves with several formulas to analyze deals effectively.
Calculations That Use NOI
Numerous other real estate calculations can help investors evaluate potential deals, some of which include NOI as a variable. These are just some of the other calculations that involve NOI:
Capitalization Rate: The capitalization rate, or cap rate, of a property is another calculation used to show a property’s potential rate of return. The formula uses NOI divided by the current market value, multiplied by 100.
Debt Service Coverage Ratio: Debt service coverage ratio (DSCR) is typically used by lenders to determine whether or not to finance a specific property. The formula looks at NOI in relation to the annual mortgage debt service to show the potential cash flow.
Return On Investment: Return on investment (ROI) is calculated by taking the NOI and dividing it by the purchase price of a property, then multiplying by 100 to get a percentage. ROI is another calculation used to help investors gauge a property’s potential.
Cash On Cash Returns: The cash on cash investment formula looks at NOI in relation to the initial cash investment made on a property. This can help investors estimate the annual cash returns of a deal.
Pros & Cons Of Using NOI For Investment Properties
The net operating income formula has developed a reputation for serving investors well. However, it is worth noting that even a perfect NOI real estate equation has its flaws. There are both pros and cons to using this evaluation strategy, not the least of which include:
Pros Of Using NOI Formula
The net operating income of a subject property can help investors determine an initial value.
NOI real estate formulas award investors with an overview of what to expect from ongoing revenue.
The real estate NOI value can help lenders determine whether or not the property represents a risky investment.
Cons Of Using NOI Formula
Knowing how to calculate net operating income isn’t universal, and can change from investor to investor.
Depending on how the asset is managed, the NOI may be inconsistent.
If projected rents prove inaccurate, the NOI will be impacted negatively.
NOI Vs. EBIT
Earnings before interest and taxes (EBIT) is determined by subtracting the company cost of goods sold (COGS) and operating expenses from its revenue. EBIT is typically used to review company performance by focusing on key operations. Similar to NOI, the number excludes taxes and interest.
On the other hand, NOI is used to analyze a property’s ability to generate income in the real estate market. Although NOI does not take depreciation or amortization into account. Essentially, EBIT accounts for more potential costs associated with an investment than NOI because of this.
As an example, let’s say an investor purchases a property expected to generate $15,000,000 in rent and servicing fees. With operating expenses of about $4,000,000 and depreciation expenses of approximately $100,000, the EBIT would be around $10,900,00 while the NOI would be around $11,000,000 since EBIT takes depreciation expenses into account.
How To Improve NOI
As I mentioned above, NOI can be used to evaluate both new and existing properties in your investment portfolio. If the NOI of a property is negative or simply not where you want it to be, there are three main areas you can focus on. The following tips can help you improve NOI and boost your investment’s performance:
Minimize Operating Expenses: Unnecessary operating expenses can undermine your profit potential if you are not careful. If your property expenses seem too high, or you have not reviewed them in a while, try looking at your budget for anything that can change. You may need to reevaluate your property management company, look for ways to save energy to lower utility costs, or even raise leasing fees to cover property amenities.
Increase Rental Income: The other half of NOI comes from your rental income. You can look at the property value to determine if a rental increase is in order, though this is not the only way to boost income. You can also try evaluating how many vacancies are in the property and how quickly properties are turned over. It may be time to improve your marketing, speed up move-in timelines, or even add signing incentives for new tenants. These tactics can help reduce your vacancies and, in turn, boost your rental income.
Find Extra Income: If you have already implemented changes to your operating expenses and filled vacancies, there is still another way to improve NOI. You can try to add additional income sources to the property. This could include adding paid parking, charging for pet rent, or even improving apartment amenities for extra money.
What Is A Good NOI?
NOI is a number that evaluates the revenues generated by a property relative to its expenses. You can use it to compare the value of the property as if you’d had paid for it fully in cash. This means that you want an NOI that is higher relative to the purchase price of the property.
Summary
The right real estate calculations can allow investors to evaluate properties and make informed investment decisions. Now that you can answer the question “what is net operating income in real estate,” you should be more prepared to use the metric as you analyze deals. Remember, NOI real estate formulas can serve as a basis for evaluating potential properties and can even be used in conjunction with other real estate calculations to analyze deals further. By understanding NOI, investors will be better equipped to estimate their potential deal’s income and succeed in real estate.
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