Net operating income (NOI) is an important real estate profitability metric to help you calculate the potential revenue of an investment property. NOI provides valuable data for determining whether to buy a property, estimate potential rental income, or increase rents to boost cash flow.
The NOI formula is straightforward. You subtract operating expenses from gross operating income (GOI) to calculate the potential profitability of the asset. In other words, net operating income is the difference between the cost of operating the asset and the amount of revenue it generates.
Net operating income does not use expenses such as loan payments, mortgage payments, depreciation or capital expenditures in the calculation. However, it helps you to compare properties while buying or selling real estate. As a result, some investors consider it the most important metric in real estate investing.
This article explains why NOI is important in making real estate investment decisions.
What is Net Operating Income (NOI)?
Net operating income is an easy formula for calculating potential rental revenue from an income-generating property. The formula uses two metrics – estimated rental income and all expenses. The net operating income figure is a property’s total income minus operating expenses.
How Net Operating Income (NOI) Relates to Real Estate
The beauty of using the NOI formula is that it is a simple calculation to determine an asset’s operating performance. Here’s what it means in the context of real estate:
- NOI and Real Estate Investments: Calculating the difference between gross operating income and operating expenses is important when evaluating different properties. You can easily estimate the income potential from single-family homes, condos, and multi-family properties. Putting the data side by side helps you evaluate the best investments.
- NOI and Your Rental Portfolio: The Net Operating Income formula is also helpful in estimating the profitability of your existing investments. For example, a simple analysis may show that the NOI has changed since the property was purchased. This may mean that you should start looking for ways to find additional revenue. Or you may decide to sell the rental unit because of the revenue loss.
NOI Formula
The net operating income formula is:
Net Operating Income = Gross Operating Income – Operating Expenses
Here are some helpful explanations to help break down the formula:
- Total: The total amount of revenue before deducting fees, expenses, taxes, or commissions.
- Net: Your “take home” amount after all related expenses have been paid.
Let’s say the annual operating revenue from a single-family rental unit is $21,600. it is gross operating income, However, let’s say the ongoing expenses amount to $4,800 annually. This means your net income after operating expenses is $16,800.
How to Calculate Net Operating Income (NOI)
Although the NOI formula is straightforward, there are many variables you must consider in order to get an accurate picture of an asset’s potential profitability. For example, you must allow for vacancy rates, all operating expenses and additional income sources to figure out NOI. Potential income fluctuations are also included in the calculation.
Here are some variables to consider regarding expenses and income.
Gross Operating Income (GOI)
Ideally, you can calculate the GOI by multiplying the monthly rent by 12 to determine the gross annual income. However, it is important to remember that income can fluctuate depending on vacancy rates and potential sources of additional income. In addition, you face the very real possibility of the tenant not paying the rent.
Here are the factors to consider when calculating gross operating income:
- vacancy rate: A vacant rental unit affects your potential cash flow. Therefore, factor vacancy rates using metrics from comparable properties or information from the current rental property owner.
- Loan Loss: It is wise to keep an eye out for occasions when a tenant does not pay their rent. Like financial loss through vacancies, credit loss affects your bottom line.
- Additional Income: Does the condo or multifamily property have additional sources of income? Here are some examples:
- veining machines
- washing machine like washing machine
- Parking Fee
Connected, How to increase rental income.
operating expenses
It is important not to confuse income with cash flow. Therefore, it is important to know which expenses to include in the net operating income formula and which to leave out.
Here are the operating and non-operating expenses included in the NOI calculation:
- Asset maintenance and repair costs
- home owner insurance
- property management fee
- Other landlord-related expenses such as accounting and attorney fees
- property taxes
Because NOI is used to measure a property’s ongoing revenue, capital expenditures are not included. Therefore, you do not have the following capital expenses:
- Income tax
- asset depreciation
- capital expenditure such as new roofing
- asset depreciation
- mortgage payments
Why are mortgage payments excluded from operating expenses? After all, paying off the mortgage may be your biggest monthly expense. This is because mortgage payments depend on individual investors, not the overall health of the property.
net operating income vs gross operating income
The difference between net operating income (NOI) and gross operating income (GOI) is how expenses affect results.
gross operating income The net income potential from the property considering vacancy and credit losses is. It is also important to include additional income sources that are not included in the rent.
net operating income Revenue is when daily expenses and fees are considered. NOI is the amount you are left with after deducting the cost of the rental property.
Net Income vs Operating Income?
The primary difference between net operating income and net income is the type of expense involved. Operating income simply refers to revenue minus the day-to-day running costs of owning a rental property. Net income is your bottom line. This factors in all loans, mortgage payments, operating costs and additional income streams.
In short – operating income is the profitability of a rental property and is the most important metric when comparing individual investment properties.
Examples of Net Operating Income
Net operating income measures the potential income stream from a real estate investment. Typically, you calculate the figure annually to account for the variation in income and expenses from month to month.
Here is an example of calculating NOI using the formula “GOI – Operating Expenses = NOI,
Let’s say you’re considering an investment property – a small multi-family property with five rental units. Here are some statistics:
- Monthly rent for each unit – $1,600
- Potential Annual Rental Income – $96,000 ($1,600 x 5 x 12)
- Annual income from coin laundry machine — $1,200
We should also take into account the loss of vacancies to find out the actual Indian Govt. The average for the region is 10%. The calculation is $96,000 x 10% = $9,600. Therefore, our gross operating income is:
- $87,600 ($96,000 + $1,200 – $9,600)
The current owner’s accounts show that the annual property expense for the previous year was $16,500.
Here’s our net operating income calculation:
- $87,600 – $16,500 = $71,100
This real estate metric can compare a property to other potential investments. Additionally, you can work out if you can cover your mortgage payments and calculate the value of the property.
The NOI calculation also helps you figure out the total return on investment – the capitalization rate.
NOI and capitalization rate
Calculating net operating income helps determine other metrics such as the capitalization rate. Also called cap rate enables you to decide about the potential return on investment (ROI).
Here’s how to use the NOI and cap rate formula:
Capitalization Rate = Net Operating Income ÷ Purchase Price
For example, let’s say the five-unit property in our example has a listing price of $460,000. Then, we can use the cap rate formula to calculate the rate of return on investment.
- $71,100 ÷ $460,000 = 15%
Therefore, you can use the NOI and capitalization rate to determine your annual return and if the investment is sound.
Connected, How to calculate cap rate.
What is an ideal net operating income percentage?
A common question in real estate investing is what is the best NOI percentage? Net operating income is not expressed as a percentage. Instead, it’s the number you get when you subtract operating expenses from gross operating income.
Most investors use loans or finance for real estate investment. Therefore, it is essential to take into account the cost of financing when valuing assets, calculating the cap rate, and calculating the cash flow of your business.
Generally, it would be best to look for properties with higher net operating income compared to the price of the property. Most real estate investors agree that margin and operating income should be above 15% of investment cost.
Summary
Calculating net operating income is invaluable when comparing real estate investments. And the good news is that calculating NOI is easy and helps you quickly identify potentially profitable investments. A higher NOI usually indicates a better investment opportunity.
Note by BigPockets: These are the views expressed by the author and do not necessarily represent the views of BigPockets.
