Summary: In this article we’ll answer the questions, what is net operating income in real estate and why does it matter? Topics also include: how to calculate NOI in real estate, when to use NOI, examples of net operating income, the pros and cons of NOI, other helpful real estate formulas and more.
Introduction
Analyzing an investment property can seem like a big task, especially for new real estate investors. It’s a good thing there’s a quick way to determine whether a rental property might be a profitable investment. Investors can figure out the value of a property and it’s income-producing potential by calculating the net operating income or NOI.
Understanding and using NOI in real estate is a helpful tool by itself, but it’s also key to other important formulas used by real estate investors to analyze and compare properties.
What is NOI in Real Estate?
Net operating income in real estate is the money a property generates minus operating expenses. It is used to evaluate how much cash flow an investor can expect to earn from an investment property after operating expenses and vacancy losses.
There are certain costs that qualify as operating expenses and others that don’t. Operating expenses that should be deducted might include property tax, insurance, repairs and maintenance.
NOI doesn’t include depreciation, capital expenses, loan interest and loan payments, depreciation and amortization.
How to Calculate Net Operating Income in Real Estate
The formula for NOI is generally accepted and used by real estate investors to determine the potential rental income of a property. Use the following formula to calculate NOI:
NOI = Gross Operating Income – Operating Expenses
In order to understand exactly how to come up with an investment property’s NOI, first we need to define gross operating income. Then we’ll outline what qualifies as an operating expense.
Gross Operating Income or GOI is the amount of rental income earned from an investment property. GOI can include fees or any other revenue produced by the rental property.
Operating Expenses are the day-to-day costs of owning a real estate asset. These ongoing operating expenses include property management fees, repairs and maintenance, utilities, insurance, and property tax.
Expenses Included in NOI
The following expenses would be considered qualified operating expenses when calculating net operating income:
- Property Management Fees
- General Maintenance & Repairs
- Utilities (if not paid by tenants)
- Property Taxes
- Insurance Costs
- Legal Fees
Expenses Not Included in NOI
Mortgage payments and mortgage interest are not considered operating expenses.
Other expenses that would not be considered operating income when calculating NOI:
- Mortgage Payments
- Mortgage Interest
- Debt Service
- Property Depreciation
- Tenant Improvements
- Major Improvements (that increase a property’s value substantially)
- General Costs For Wear-and-Tear
Examples of Using NOI in Real Estate
NOI helps both lenders and investors analyze a deal and decide if it works for them or not. A real estate investor will use NOI to either move forward with buying a property or move onto the next. The lender will, in essence, do the same with a loan. Let’s examine the following examples of how to use NOI in real estate.
Example of How Investors Use NOI in Real Estate
Let’s say Kelley is looking to invest in a rental property and needs to calculate the NOI.
The property makes $100,000 in income every year and incurs $75,000 in operating expenses and vacancies.
Kelley’s annual NOI would be $25,000 ($100,000 – $75,000).
But how did we get there? Start with adding up all the money coming in from rents and any other additional income.
Money coming in: $90,000 from rents + $10,000 from other income = $100,000
Money going out: $60,000 operating expenses + $15,000 vacancies = $75,000
With NOI in hand, Kelley can now see whether she should continue pursuing this particular investment property, compare it with another or move onto the next.
What if a property’s NOI is in the negative? In the event a rental property isn’t earning enough money to cover operating expenses, the investor will experience a net operating loss or NOL. If a potential investment property is already showing a net operating loss, it’s probably best to consider other properties.
Example of How Lenders Use NOI in Real Estate
Using the same numbers from the above example, our NOI is $25,000.
Lenders will do their own due diligence and adjust the NOI based on their findings. Lenny the Lender considers what the fair market value of rents are in the area, including average vacancy rates.
It’s likely Sally’s NOI calculation is slightly more generous than Lenny’s. That’s because Lenny needs to make sure the risk of lending Kelley money isn’t greater than the reward. Lenny will then take the NOI and divide it by the annual mortgage payment amount to get the DSCR. To reiterate, the DSCR helps lenders determine if the investor can afford to pay back the loan.
Please note: lenders will use DSCR when evaluating larger investment loan applications, i.e. commercial, multi-family and business.
When to Use NOI in Real Estate
Both investors and lenders will use the net operating income formula to determine how profitable a real estate investment will be. Calculating the NOI will indicate to lenders whether the investment property will produce enough cash flow to cover loan payments.
Banks will often use NOI before giving the green light on a commercial loan. The lender needs to know that the investor can pay back the loan with the potential cash flow.
Ways to Increase Your NOI
In order to secure a loan on a rental property, sometimes investors will look for ways to increase net operating income. Investors might find extra ways to cut expenses or choose to put off certain expenses, while pushing certain expenses forward. On the flip side, property owners may also choose to increase rents or fees to improve their net operating income.
Rental property owners can find different streams of revenue to help boost ROI. Some of these amenities could include:
- Covered parking fees
- Coin-operated laundry facilities
- Vending machines
- Charge pet rent
Consider this: let’s say you own an apartment building and your property manager lives in the building. In exchange for their property management services, they get to live for free. Rather than paying a building manager $30,000 a year, you waive the tenants rent of $15,000 annually.
The “reasonably necessary” cost of $30,000 may be subtracted from the property’s total revenue, even though your actual cost is just $15,000.
There are a number of ways rental property owners can increase their ROI by cutting or delaying certain expenses. Look for ways to cut utility costs by setting up timers for outside lights to go on and off or find a less expensive property manager. Smart investors and property managers come up with creative ways to cut costs and increase the NOI.
Pros & Cons of Using NOI For Investment Properties
The net operating income formula is used by real estate investors all the time. It can be a super helpful metric, but it does have its shortcomings. There are other metrics in real estate that investors should consider before buying a rental property…
Pros of Using NOI For Investment Properties
- NOI helps determine the initial value of a potential investment property.
- NOI gives investors a good idea of how much revenue to expect moving forward.
- NOI shows lenders if the rental property is a safe investment or not.
Cons of Using NOI For Investment Properties
- Future rents and cash flow can be difficult to predict–making NOI sometimes inaccurate.
- NOI may vary based on how the asset and property are managed.
- Investors use different methods to calculate NOI–it isn’t universal.
Real Estate Formulas with NOI
NOI can be used as a stand alone metric to determine the value of a potential rental property and its ability to earn cash flow after operating expenses. But it’s also vital when calculating other helpful real estate formulas.
The following formulas require NOI:
- Capitalization Rate in real estate reveals a property’s potential rate of return based on its purchase price. Investors will often compare similar properties using cap rate. NOI / Purchase Price = Cap Rate.
- ROI is the amount of return you receive from an investment after expenses. ROI is expressed as a percentage. NOI / total investment = ROI.
- Cash-on Cash Returns are calculated pre-tax and measure how much cash you invested compared to the amount of cash flow you receive. Annual pre-tax cash flow / total cash invested = cash on cash return.
- Debt Service Coverage Ratio or DSCR is a formula used by lenders to determine if a borrower can afford to cover the mortgage plus operating expenses on an investment property. Basically, lenders use DSCR to weigh the risk versus reward before approving a loan to an investor. Annual NOI / Debt Obligations (loans) = DSCR.
Net Operating Income FAQs
FAQ 1: Operating Income vs. Net Income
Operating income and net income are similar, but have several major differences. While both are revenue, operating income is the money left after operating expenses have been deducted. This income would be from rents, laundry or parking fees. These operating expenses would include things like property management costs, amortization and depreciation.
Whereas net income is the amount of revenue a property generates after expenses, including taxes and interest. Net income is essentially your bottom line.
FAQ 2: NOI vs. EBIT
EBIT or Earnings Before Interest and Taxes takes a property or company’s income and subtracts its expenses. EBIT does not include taxes and interest, but it does consider expenses related to depreciation and amortization. Basically, EBIT appraises the profitability of an investment or business.
Conclusion
Net operating income in real estate is an essential part of analyzing and comparing potential investment properties. Having said that, NOI is only useful if it’s accurate. For investors buying an existing rental property, it’s a good idea to ask the current owner for all the previous rental information they have. And do your own research to find out how much people are charging for rent in places similar to yours.
If you’re an investor looking to buy a new build rental property, you won’t be able to rely on the historical rental data. However, there are a number of resources available just online to help you evaluate rental trends in the area you are looking to invest in.