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By Allison Bethell on September 24, 2018 | Accounting, Glossary, Real Estate Investing
Net Operating (NOI) is a calculation of the income generated by a real estate investment. It measures the amount of cash flow generated by an investment property after operating expenses, but before principal and interest payments, capital expenditures, depreciation, and amortization. Investors use NOI to determine the value and profitability of an income-producing property.
What Net Operating Income Is
In real estate investing, net operating income is the amount of income collected from an investment property after you subtract the operating expenses and vacancy losses. Real estate investors look at a property’s net operating income to determine if the property is a good investment.
They also analyze the NOI of a property that they already own to help determine if they need to raise rents to increase their cash flow. Unlike with cap rate, there isn’t a “good” NOI. Instead, investors can compare the NOIs between properties and use the current NOI to see if their expenses are too high, rents too low, or if the property is unaffordable once they add in their mortgage payment.
Net operating income is generally calculated on an annual basis. So, if you know what your monthly income and expenses are, you just multiply by twelve to get your yearly totals. Keep in mind that NOI should be used in addition to other evaluation tools, such as cap rate, ROI, comparable properties rental income, and cash flow. We recommend using NOI and one of the other tools to best understand the investment property’s overall financial standing.
How to Calculate Net Operating Income
You can calculate net operating income (NOI) for your real estate investment by using the generally accepted net operating income formula, which is your potential rental income plus any additional property-related income minus vacancy losses minus total operating expenses.
Keep in mind that the net operating income formula can vary depending on who’s calculating it.
For example, most investors separate potential rental income and other income, but sometimes you will see them combined. Regardless, the generally accepted net operating income formula is your potential rental income plus any additional property-related income minus vacancy losses minus total operating expenses.
Using an NOI calculator will make it much easier, so check out our free net operating income calculator.
Net Operating Income Formula
The net operating income formula:
NOI = Rental Income + Other Income – Vacancy Losses – Total Operating Expenses
In order to figure out a property’s net operating income, you need to know the potential rental income and other income it produces. You also need to account for vacancy losses from vacant units or units where tenants aren’t paying rent. Lastly, you need to add up all of your operating expenses. Once you have all of those numbers, you can calculate the net operating income of an investment property.
To find your net operating income, you typically need:
- Potential Rental Income of an Investment Property
Potential rental income (PRI) is the combined total rent under the terms of each individual residential or commercial lease, with the assumption that the property is 100 percent occupied. If the property is not fully occupied, then the amount of PRI is based on a rental market analysis, according to the leases and terms of comparable properties.
- Vacancy Losses on an Investment Property
Vacancy losses represent the loss of income due to tenants vacating the property and/or tenants defaulting on their lease payments. The vacancy factor can be calculated based on current lease expirations. Market-driven figures using comparable property vacancies can also be used for the purpose of calculating a property’s NOI.
To calculate vacancy losses, look at what that unit could have rented for and multiply it by however many months out of the year it was vacant. For example, if other similar units rent for $2,000 per month and the vacant unit was empty for three months, you would multiply $2,000 by 3 and get $6,000, which is the yearly vacancy loss for the property.
- Other Income on an Investment Property
Because there are many different ways a property can generate income, real estate investors need to include all possible revenues in their calculation, in addition to monthly rent. These other revenues include, but are not limited to, facility rental proceeds as well as proceeds from vending machines, proceeds from laundry services, income generated from parking fees, billboard/signage fees, and other relevant service charges.
- Total Operating Expenses on an Investment Property
Total operating expenses include all necessary expenditures associated with operating and maintaining an investment property. To get the total operating expenses, you simply add up all of the operating expenses such as property taxes, maintenance, and management fees.
Specifically, operating expenses typically include:
- Property Taxes: These are assessed by a governing authority in the area the property is located and vary based on location, property value, and size.
- Rental Property Insurance: This helps protect your property from loss of income, damage, and perils such as weather-related damage. The average policy on a $200,000 rental property costs $1,473 to $1,596 per year.
- Property Management Fees: These fees are charged by a property manager or management company and can vary from 8 percent of gross collected monthly rent for an investment property to over 25 percent of gross rent for a vacation rental property.
- Maintenance and Repairs: These include things to keep the property maintained, like pest control, painting, and lawn care, as well as any necessary repairs. Expect to pay about 1 percent of the property value per year on maintenance-related expenses.
- Miscellaneous Expenses: These can include things like legal fees, marketing and advertising expenses, and anything else needed to operate the property that doesn’t fall under another category.
Expenses Not Included in NOI
It is important to note that debt service, depreciation, leasing commissions, tenant improvements, repairs to wear and tear, income taxes, and mortgage interest expenses are not included in the calculation of net operating income. This is because NOI is unique to the property itself and does not include other expenses that are specific to the investor/borrower.
When to Use Net Operating Income
Before a purchase, an investor can use NOI to assess a property’s value, helping them to make a more informed investment decision. After the purchase, NOI can be used as a measure of operating cash flow.
Lenders who finance an investment property are also interested in knowing the net operating income of the property. This is because NOI is sometimes used as one of the deciding factors in approving a commercial loan for real estate investors. Lenders will look at a property’s net operating income and then assess if the owner will have enough cash flow to pay the mortgage payments. Lenders take this seriously because they want to ensure the borrower can afford to repay the loan.
“NOI is especially important to commercial lenders on multifamily assets because their risk is assessed based on the NOI of the subject property. On large multifamily units, lenders such as Fannie Mae use the NOI metric when assessing the initial value of the property instead of evaluating the borrower/investors credit risk and history.” – Veena Jetti, Founding Partner, Enzo Multifamily
Calculations That Involve NOI
NOI is used in many calculations and formulas used by real estate investors. It’s used by investors to evaluate an investment property’s ability to produce cash after operating expenses are paid.
Some of the calculations that rely on NOI include:
- Cap Rate: Shows a property’s potential rate of return; the cap rate formula is NOI / Property Value x 100.
- ROI: This is the return expressed as a percentage that you receive on an investment property; the ROI formula is Annual Return / Total investment (and the annual return is also known as the NOI).
- Debt Coverage Ratio: Used by lenders to see if a property’s income covers its operating expenses and debt payments after calculating its NOI.
- Cash Return on Investment: The amount of cash you invest in a property compared to the amount of cash you receive, taking into account its NOI.
Examples of When Net Operating Income Is Used in Real Estate
The net operating income formula is used by both real estate investors and lenders. They each want to evaluate a deal and see if it makes sense. Let’s take a look at two examples: one where an investor uses NOI to determine if they should buy a property and one example where a lender uses the NOI formula to decide if they should lend money for an investment property purchase.
Keep in mind that the net operating income formula is: NOI = Potential Rental Income + Other Income – Vacancy Losses – Total Operating Expenses
NOI Example
Let’s assume Jane wants to buy an investment property. She knows that the potential rental income is $40,000 per year, additional income is $2,000, vacancy losses are $5,000 and operating expenses are $8,000.
First, add up the gross rental income and the additional income.
$40,000 + $2,000 = $42,000
Then subtract the vacancies and operating expenses.
$42,000 – $13,000 = $29,000
So, the NOI = $29,000
Jane can then use this number and compare it with other properties in the area, and see if the property is priced right. She can also find out her estimated monthly mortgage payment and make sure she can afford it based on the NOI. Jane can use the NOI to figure out the property’s cap rate. The cap rate formula is the NOI divided by the property value, and this is used to help evaluate the rate of return on the investment property.
How Lenders Use NOI in Underwriting
Now let’s look at how lenders look at net operating income when deciding if they’re going to fund an investment property purchase. Let’s use the same numbers from example one, so the NOI = $29,000.
A mortgage lender will adjust this NOI based on the fair market value of rents in the area, and will check to make sure the vacancy losses are accounted for. They usually “play” with the numbers to get the most conservative NOI. They want to minimize their risk, and want to account for any rents that may go down or any units that may become vacant based on average vacancy rates.
A lender will also use the net operating income formula to calculate the debt service coverage ratio. The DSCR is the NOI divided by the annual mortgage payment. This helps a lender evaluate if the borrower can afford to repay the loan. Lenders use this ratio when issuing multifamily, commercial and business loans.
Pros and Cons of Using Net Operating Income
The calculation of a property’s net operating income is an important way to determine its value as well as evaluate its profitability. Still, the use of NOI in making decisions about a real estate investment has both its advantages and its disadvantaged. Let’s take a look at the potential pros and cons of NOI below.
Pros of Using NOI
Advantages of using NOI include:
- NOI determines an investment property’s initial value, helping real estate investors identify whether it will make a good investment.
- The use of NOI provides an overview of a property’s ongoing operating revenue.
- NOI also helps lenders and creditors determine whether a property generates sufficient cash flow to cover any potential debt service.
Cons of Using NOI
Disadvantages of using NOI include:
- NOI analysis can be manipulated since a property owner can choose to accelerate or defer certain expenses.
- The NOI of a property is not always constant—it can change depending on how the property is managed.
- Because other expenses are not considered in NOI (e.g., interest expense, debt service, income taxes, capital expenditures), the actual cash flow that a property can generate may differ after all these other expenses are paid.
- If projected rents are used to calculate NOI, it can throw off the net operating income formula if these rents differ from market rents.
How to Improve Net Operating Income
A property with a high net operating income is typically a good thing. A positive NOI means a property’s operating revenues are higher than its operating expenses. A negative NOI indicates that the operating expenses of a rental property exceed its revenues. To help figure this out, there are different methods to improve the NOI of a real estate investment.
Here are three ways to improve an investment property’s net operating income:
- Improve Rental Income
The main source of revenue from an investment property is its rental income. One way to improve your rental income is to make sure that you have a high occupancy rate of 90 percent or above. Another method is to review your rental rates to make sure that the rent is properly priced according to its comps and its target tenant demographic.
If you’re not sure if your rents are too high or too low, check out our guide on what to charge for rent in 2018. It will help you determine how to set a fair rent price that attracts tenants and gives you positive cash flow.
- Find Additional Income Sources
Besides rental income, many real estate investors take advantage of additional streams of revenue from their investment properties. Some popular sources of income for rental properties include parking, coin-operated laundry facilities, and vending machines. You may also consider renting out extra space to tenants for storage. If you own a multi-story apartment building, you may be able to rent out space to a billboard company.
Some other creative ways to earn additional income on an investment property include:
- Charge an extra monthly fee for cleaning services
- Charge monthly pet rent
- Rent fans and window A/C units to tenants during warmer months
- Put higher-end appliances in units for an additional monthly fee
- Upgrade kitchens and bathrooms for additional rental income
- Minimize Operating Expenses
A property’s operating expenses have a big impact on its net operating income. Therefore, it’s a good idea to cut or trim operating costs when you can. For instance, you can reduce costs on utilities by ensuring that unused lights are turned off or are on a preset timer so they only come on when it gets dark. Or you can pass janitorial expenses through to the tenants as maintenance fees instead of absorbing it as an amenity.
Additional ways to minimize operating expenses include using low-energy light bulbs, such as LEDs. These cost more than regular light bulbs upfront, but save money on electrical expenses over the long term. If you pay the water bills on a property, you can cap it at a certain amount and if the tenants go over that, then it’s their responsibility.
For more helpful landlord tips and suggestions, check out our article on landlord tips from the pros.
SEE IT ALL: https://fitsmallbusiness.com/net-operating-income-noi-formula-calculate/
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