Net operating income or NOI is an indicator used to determine whether or not a particular property is a good investment. Real estate investors can use NOI by measuring a property’s continuous operating costs to analyze its potential revenue.
NOI is an important metric that every real estate investor must know to evaluate the profitability of a real estate investment opportunity.
Net operating income can also be an important standard used to compare prospective deals or evaluate the existing property value if calculated correctly.
We are going to break down the importance of net operating income and how to use it in any real estate deal.
What is NOI?
As mentioned, NOI in real estate is one of various metrics used by real estate investors to determine the profitability of a property.
Quite often, real estate investors use NOI as a benchmark to determine the profitability and cash flow of a revenue-generating property or potential deal.
While you can use the metric to determine a property’s revenue, it doesn’t account for expenses such as interest payments, taxes, or capital expenditures. When you use NOI to evaluate a real estate deal, you can get a closer look at how profitable a property can be in relation to its operational costs.
Typically, NOI is calculated yearly; however, it is flexible enough to allow real estate investors to adapt their operating costs to any timeline. NOI excludes some financial variables such as taxes and mortgage payments, meaning it only offers a narrow view of the income-generating potential of a property. Due to this somewhat narrow scope, NOI is seen as less subjective to alterations than other real estate-specific metrics.
One drawback of using NOI to predict potential income is that the income generated depends entirely on how you operate the property. Experts recommend real estate investors be careful when referencing market factors for potential rental income.
When to Use NOI in Real Estate
NOI is typically used to determine the profitability of a residential or commercial rental property investment. It can be used by both lenders and investors when considering prospective real estate investment deals. NOI enables lenders to judge if an investor can generate enough cash flow to meet their loan payments. NOI is often used to consider commercial loan applications for real estate investors.
While NOI is seen as a trustworthy indicator in determining a property’s potential income, it isn’t the only metric investors use. There are many other formulas potential investors need to know when trying to effectively analyze deals.
How to Calculate NOI
Calculating NOI is pretty straightforward:
Income Generated From Property – Operating Expenses = NOI
Although this is simple, it is important to note that this net operating income formula is only one of many formulas used to calculate NOI. The formula used depends on the person doing the calculating.
Using the formula above, you can calculate the gross operating income by adding the rent amount the property generates in a month and then subtracting lost revenue from the vacant units. Once you have your gross operating income, you can add any additional revenue-generating items to the list, including vending machines, laundry, parking, and any supplementary service fees that come with renting a unit.
You can combine all the additional renting income with the gross operating income before calculating the next part of the formula.
The next step involves deducting the expenses that come with operating the building. Operational costs refer to any expenses associated with maintaining and running the property, like utilities, property taxes, insurance, repair costs, and property management fees.
For example, a property that has a gross operating income of $20,000 with an additional generated income of $4000, making the total income of the property $24,000. If the total operating expenses come to $6,000, the net operating income will be $18,000.
Conversely, if there is a high vacancy rate on the property and income generated was just half at $10,000 with expenses amounting to $12,000, then the NOI for that property would be -$2,000.
When the expenses are more than the generated income, the property in question will have an NOL or Net Operating Loss.
Expenses Included in NOI
Understanding NOI in real estate means knowing the expenses included in the formula and those that aren’t. Operating expenses are the daily costs incurred from operating the property. Below is a list of expenses to include in your NOI calculations.
You need to add the amount spent on insurance for the property when calculating NOI, even if you incur the costs bi-annually or yearly.
The rate of property taxes will vary from one jurisdiction to the next. However, they are an important factor when considering a property’s NOI.
Utilities Not Handled By Tenants
In some cases, the property owner elects to pay all or a part of the utilities, and their expenses influence the real estate NOI. For instance, if the landlord pays waste or sewage fees, they should be deducted from income generated when calculating a property’s NOI.
Include legal fees, whether an attorney is hired to draft a lease or the property is subject to litigation. The money spent on these fees is no different from any other expense included in NOI.
All rental properties, particularly older ones, require some maintenance, including grounds keeping, electrical, or plumbing work. And these costs need to be accounted for.
Property Management Fees
Investors incur these fees by investors who want a more hands-off approach to real estate. Landlords may choose to outsource property management to a service for a small percentage of rent collected. Nonetheless, choosing a passive real estate investment strategy comes at an expense that needs factoring in when calculating NOI.
Expenses Not Included in NOI
It is important to identify property-associated costs and investor-specific costs when determining a property’s net operating income. For example, you don’t consider mortgage interest expenses when factoring in NOI. Here are some other expenses not included in the NOI formula:
- Income taxes
- Mortgage interest
- Property depreciation
- Repair for wear and tear
- Tenant improvements
Advantages and Disadvantages of Using NOI
Investors use the NOI formula to determine the potential income property will generate for years. However, it is important to note that even a perfect NOI formula comes with its issues. Here are the advantages and disadvantages of using this metric as an evaluation strategy.
Advantages of NOI
- NOI provides investors with a potential overview of continuous revenue.
- A property’s NOI aids investors in determining a property’s initial value.
- A property’s NOI value can aid lenders in determining if a property is or isn’t a risky investment.
Disadvantages of NOI
- The method used to calculate NOI isn’t universal, meaning it can vary from one investor to another.
- NOI is negatively impacted if the projected rent is inaccurate.
What is the Relation Between NOI and Capitalization Rate?
The NOI formula aids investors in calculating the profitability of a property and represents the property’s revenue minus its operating expense.
Nevertheless, it’s worth noting that a property’s NOI does more than calculate its potential income. It can also help investors calculate its capitalization rate, which is another essential variable.
The capitalization rate of a particular property places an object value on it, making it easier for an investor to compare it with dissimilar assets. The cap rate is typically expressed in percentages so investors can compare different assets, which is particularly useful in deciding if to rent a property out or flip it.
What is a Good NOI?
As stated earlier, NOI is a value that evaluates a property’s potential generated revenue relative to its expenses. Investors can use it to ascertain the property’s value as if it is paid in full. In short, investors will always want a relatively higher NOI when compared to a property’s purchase price.
NOI is an important real estate calculation that enables investors to evaluate properties. It also helps them to make informed investment decisions.
After reading this article, you should clearly understand what net operating income is in real estate and how to use it when making critical real estate investment decisions. It is important to remember that the NOI formula can be the foundation on which to evaluate potential properties, either as a standalone calculation or in conjunction with other critical real estate formulas.
Understanding NOI provides investors with more information when investing, placing them on a path to success in real estate.