A net operating income, or NOI, is a calculation critical to the success of property owners, investors, landlords, and even property management companies! Not only does an NOI allow individuals to evaluate rental properties before purchasing them, but it also enables them to predict how an investment property will impact their overall bottom line.
This is especially useful for new investors or those with large portfolios. This article will define net operating income before discussing why it matters and how to calculate it.
What Is Net Operating Income and Why Is It Important?
First and foremost, net operating income is a calculation that allows investors to determine the profitability of a specific rental property over a period of one year. It’s important to remember that a property’s NOI can change year over year, so be sure to always calculate an NOI before making a real estate investment rather than assuming an older NOI is accurate.
NOIs are important to investors because they can indicate whether an investment will be lucrative or not. Additionally, commercial lenders will use an NOI to determine whether or not they’re willing to offer a loan to an investor.
The equivalent to an NOI in other industries is called “earnings before interest and taxes” or EBIT. It is important to note that net operating income is different from net income, which is defined as revenue after subtracting all operating and non-operating expenses.
Similarly, net operating income is not the same as gross operating income. In real estate gross operating income is the total potential income from a property after subtracting any income lost to vacancies.
What Is a Good NOI?
Which NOIs vary by property, there are ways you can determine whether an NOI is good or not. Generally, an NOI that is higher than the real estate property price percentage is ideal.
How to Calculate NOI
Fortunately, the formula for calculating NOI is relatively simple. The net operating income formula is:
Real Estate Revenue – Total Operating Expenses = NOI
For example, if you own a property that earns you $200,000 a year and incurs $95,000 in operating expenses, then your NOI is $105,000. While this is a relatively healthy NOI, some properties won’t generate enough income to cover the property’s expenses.
For instance, if your property earns $100,000 a year and your expenses are $120,000, you would have a net operating loss of $20,000.
Components of an NOI
There are two components that are used to calculate net operating income. They are as follows.
Real Estate Revenue
There are two parts to real estate revenue in an NOI, potential rental income and other income. Rental income is defined as the amount of rent a landlord collects from a rental property. When you calculate net operating income, you should assume the rental will be occupied 100% of the time.
If you haven’t purchased the property yet, we recommend analyzing rental comps or other real estate tools to find its potential rental income.
Other income is any revenue you gain that isn’t from rent payments. This kind of income is often derived from paid parking spots, pay-per-use washing machines, or even vending machines in multi-unit properties.
Total Operating Expenses
Total operating expenses are the second variable needed to calculate an NOI. This variable includes far more factors than real estate revenue. In short, these expenses include all expenses required to maintain the rental property, regardless of whether it is occupied or not.
The factors you consider when determining a property’s operating expenses include:
- Vacancies
- Property taxes
- Insurance
- Maintenance and repairs
- Property management fees
- Legal fees
- Marketing and advertising
- Utilities not paid by tenants
What Expenses Are Excluded from NOI?
When calculating net operating income, it’s crucial to determine when a cost is associated with the investor and when it’s related to the property itself. Because net operating income is directly tied to the property, the below should not be included in the operating expenses.
- Interest on mortgage payments
- Personal income tax
- Leasing commissions
- Debt service
- Property depreciation
- Tenant improvements
- Capital expenditures
- Repairs for wear and tear
How to Improve Your NOI
There are a number of ways you can improve your net operating income, and your bottom line. The most common ways to do so are:
- Reduce your operating expenses
- Raise your rental income
- Source additional income
NOI Cap Rate
Capitalization rates, or cap rates, place an objective value on a property and make it possible to compare diverse assets. This is particularly useful for real estate investors who are trying to decide whether to rent out a property or flip it for a profit. To determine a capitalization rate, you can divide your NOI by the total cost of the property.
Calculations That Use an NOI
In addition to capitalization rates, many other real estate calculations call for the use of net operating income. These include the:
Debt Service Coverage Ratio (DSCR)
This ratio is used to determine whether a lender will finance a specific property. It considers the NOI in relation to annual mortgage debt services as a means to determine the potential cash flow of the property.
Return on Investment (ROI)
To calculate an ROI, divide your net operating income by the purchase price of a property and multiply the result by one hundred to determine its percentage.
Cash-on-Cash Returns
This examines an NOI as related to an initial cash investment to aid investors in determining annual cash returns on a property.
Bottom Line
Whether you own a property or are looking to invest in one, you can use the net operating income calculation to determine whether your investment is or will be lucrative. Making investment decisions can be difficult, even for seasoned real estate investors, so it’s always important to understand the current NOI of your investments.
