Analyzing an investment property can seem like a daunting task, especially for new real estate investors. Thankfully, there’s a quick way to determine whether a rental property might be a profitable investment or a dud by calculating its net operating income (NOI).
Understanding and using NOI in real estate is a helpful tool by itself, and it’s also a key to other 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 evaluates how much cash flow an investor can expect to earn from an investment property after operating expenses and vacancy losses.
Certain costs qualify as operating expenses, and others 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. The formula is:
NOI = Gross Operating Income – Operating Expenses
To understand exactly how to calculate an investment property’s NOI, we first need to define gross operating income. Then, we’ll outline what qualifies as an operating expense.
Gross Operating Income, or GOI, is the 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 Net Operating Income
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 Net Operating Income
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 Net Operating Income
Net operating income helps lenders and investors analyze a deal and decide whether it works for them. A real estate investor will use NOI to either move forward with buying a property or move on to 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 wants to invest in a rental property and needs to calculate its net operating income.
The property makes $100,000 in income annually 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 from rent 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 on to the next.
What if a property’s NOI is negative? If a rental property isn’t earning enough money to cover operating expenses, the investor will experience a net operating loss (NOL). If a potential investment property is already showing an NOL, 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 the fair market value of rents 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 ensure the risk of lending Kelley money isn’t greater than the reward. Lenny will then divide the NOI by the annual mortgage payment amount to get the debt service coverage ratio or DSCR. The DSCR helps lenders determine if the investor can repay the loan.
Please note: lenders will use DSCR when evaluating larger investment loan applications, such as commercial, multi-family, and business.
When to Use Net Operating Income
Both investors and lenders will use the net operating income formula to determine the profitability of a real estate investment. Calculating the NOI will indicate to lenders whether the investment property will produce enough cash flow to cover loan payments.
Banks often use NOI before granting a commercial loan. The lender needs to know that the investor can repay the loan with the potential cash flow.
Ways to Increase Your NOI in Real Estate
Sometimes, investors look for ways to increase net operating income to secure a loan on a rental property. They might find extra ways to cut expenses or postpone certain expenses while pushing certain costs forward. Conversely, property owners may also increase rents or fees to improve their net operating income.
Rental property owners can find different streams of revenue to help boost your return on investment (ROI). Some of these amenities could include:
- Covered parking fees
- Coin-operated laundry facilities
- Vending machines
- Charge pet rent
For example, 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.
Rental property owners can increase their ROI by cutting or delaying certain expenses. For example, they can 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 devise creative ways to cut costs and increase the NOI.
Pros & Cons of Using NOI For Investment Properties
Real estate investors use the net operating income formula frequently. 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 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 whether a borrower can afford to cover the mortgage plus operating expenses on an investment property. 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
What is 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 rent, laundry, or parking fees. Operating expenses would include things like property management costs, amortization, and depreciation.
Meanwhile, net income is the revenue a property generates after expenses, including taxes and interest. Net income is essentially your bottom line.
What is 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. EBIT appraises the profitability of an investment or business.
Final Thoughts
Net operating income in real estate is essential to 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 looking to buy new build rental property, you won’t be able to rely on 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 such as RentCast and Zillow.
