What is NOI?
NOI is short for net operating income and is a number that is used to calculate the profitability of an income-generating real estate investment such as a rental property. Property investors use NOI to analyze and compare investments as well as to calculate the cap rate of a property.
How do you calculate net operating income?
The net operating income on a property is simply the gross income it generates minus your operating expenses. Calculating NOI in real estate is relatively simple as it does not take into account capital expenditures, principal and interest payments, depreciation, or amortization. To calculate your net operating income, simply add your rental income and other income together and then subtract vacancy and losses and operating expenses.
Make sure not to forget any non-rent related income the property generates when you calculate the total revenue the property brings in. This can include income from parking fees, on-site laundry machines, and vending machines.
Vacancy and credit loss refers to the rental income you don’t collect due to apartment turnover when tenants move as well as when they don’t pay any rent that’s owed. This is best estimated by looking at comparable properties and how they perform.
Net Operating Income Formula
NOI = Gross Income - Operating Expenses; or
NOI = Rental Income + Other Income - Vacancy Loss - Operating Expenses
For example, let’s say you have a 10-unit property with each apartment renting for $1,000/month. Additionally, you rent 5 parking spots for an additional $100/month each. Your property has a 10% vacancy loss and $2,000 in monthly operating expenses. Here’s how you would calculate your NOI:
$120,000 (rental income) + $6,000 (Other Income) - $12,000 (Vacancy loss) - $24,000 (Operating expenses)= $90,000 net operating income. As you can see, NOI is generally calculated on an annual basis, but it’s relatively simple to also calculate your monthly NOI by dividing this number by 12. In our example, the monthly NOI would be $7,500.
The benefits of using the NOI formula are that it provides excellent insight into the potential revenue a property can generate on an ongoing basis. This analysis is not only useful for investors but also for lenders as by calculating net operating income on a property, they can better determine whether or not the investor will have enough cash flow to make payments on their loan.
What are operating expenses in real estate?
Real estate operating expenses include all costs associated with maintaining the property and running the business. The main components of real estate operating expenses include property taxes, insurance, utilities, and property maintenance and upkeep expenses. This means that all costs associated with managing the property, from legal and accounting to contracted services like lawn care, cleaning, snow removal, and repairs are operating expenses. When you consider that some of these expenses may be seasonal or only payable once per year, it makes sense why net operating income is calculated on an annual basis.
Capital expenditures, which are used to upgrade or enhance a property, are separate from operating expenses and are not included in NOI calculations. Marketing expenses can be both an operating expense or capital expenditure, depending on how necessary the marketing is for running the business. For example, any costs associated with listing an apartment online would likely be an operating expense. In contrast, the cost of building or upgrading your property website would be a capital expenditure.
Is a mortgage payment an operating expense?
Your NOI does not include your mortgage or any debt-related expenses. All that is included in your net operating income is your gross income minus your operating expenses. NOI lets you compare investments to one another regardless of if you purchased them all-cash or financed and have a mortgage.
If you have a mortgage on a property, you might find it useful to calculate the cash flow instead of the net operating income as that takes into account all expenses, including debt payments. Cash flow is sometimes also referred to as net income.
How to interpret net operating income
The net operating income of an income-producing property can give an owner or investor a very clear picture of the property’s potential cash flow. This is thanks to the fact that it is incredibly difficult to manipulate NOI. The only way to change the NOI on a piece of real estate is to increase the gross rental income or to cut operating expenses. Overall, you can use NOI to determine how well a property is being managed compared to comparable properties in the area or even in comparison to other properties you may own.
Another way to use NOI is for trend analysis to better understand how a property is performing. By looking at how a property’s net operating income has changed over time, you can see if it’s performing well or if the NOI is dropping, which might mean you need to take action to remedy the problem or even consider selling.
NOI is also a key component in the formulas for other important calculations, such as determining the cap rate or the debt service coverage ratio of a property. The cap rate can help you determine your expected ROI, while the DSCR will be used by lenders to evaluate your ability to meet your debt obligations. The formula a lender will use to calculate the DSCR is to take the property’s NOI and divide it by the debt service (mortgage principal and interest payments). For example, if a property has $90,000 in NOI and $45,000 in annual debt service, the DSCR is 2. Naturally, the higher the net operating income, the more favorably the lender will look upon the deal. Most lenders will also require a minimum DSCR of 1.20 or higher.
Pros and Cons of Using NOI in Real Estate
While net operating income is a great metric to look at when determining whether or not to make a real estate investment, it’s not a perfect metric. Here are some pros and cons of using NOI.
Pros Of Using NOI Formula
NOI real estate formulas give investors great insight regarding what to expect from ongoing revenue.
The real estate NOI value is useful in helping lenders determine if the property represents a risky investment.
Cons Of Using NOI Formula
The NOI is prone to be inconsistent as it depends on how the property is managed.
If the projected rents prove to be inaccurate, the NOI will be impacted negatively.