NOI in real estate is one of several metrics used by investors to determine how profitable a property is. Most frequently, net operating income is a benchmark used by investors to determine the amount of cash flow and profitability of a potential deal or income-generating property. NOI is a strong indicator of a property’s ongoing revenue, though it does not account for capital expenditures, taxes or interest payments. Instead, NOI is used to determine how profitable a property is on its own.
By using NOI to evaluate a deal, real estate investors can get a better look at the potential profitability of a property in relation to how much it would cost to operate it. NOI is typically calculated on an annual basis; although, investors can easily adapt the operating costs by dividing expenses by twelve. By excluding financial factors such as mortgage interest and taxes, NOI provides a specific look at the income a property can generate on its own. Because of this, NOI is thought to be less subject to manipulation when compared to other real estate calculations.
The only challenge in predicting NOI is that the potential income will depend entirely on the way the property is being operated. Investors should be careful to use market factors as a reference when estimating potential rental income.
How To Calculate Net Operating Income
NOI for real estate is calculated by using the total income generated from a property and subtracting the operating expenses. Start by adding up rental income and any other revenue generating items on the prospective property. This can include fees for parking, laundry and vending machines, and any service fees.
Next, combine the operating costs of the subject property together. Operating costs refer to any costs associated with running and maintaining the property on a given basis. These will include insurance costs, utilities, property management fees, property taxes and repair costs.
As an example, if the total income of a property was $10,000 and operating expenses averaged around $4,000, the net operating income would be at $6,000. If, on the other hand, the total income was at $4,000 and the operating expenses were at $10,000, the NOI would instead be -$6,000. In cases such as this, with expenses totaling more than the income generated, it would be called a net operating loss (NOL).
NOI & Cap Rate
The net operating income formula is specifically designed to help investors calculate the profitability of an income generating asset, not unlike a rental property. Done correctly, real estate NOI will represent all of an asset’s revenue minus every single operating expense. It is worth noting, however, that an asset’s net operating income can do more than determine its revenue potential; it can help investors determine another important variable: capitalization rate (cap rate). The cap rate of a subject property will simultaneously place an objective value on the home and make it possible for them to compare dissimilar assets. A property’s capitalization rate is expressed as a percentage, and can therefore be used to compare assets that are otherwise different—something that come in particularly handy when trying to decide whether to flip a home or rent it out.
What Expenses Are Included In NOI?
The key to understanding the NOI real estate term is knowing which expenses are included and which are not. As a general rule, operating expenses should refer to any day-to-day costs associated with running the property. The following is a list of examples:
- Property Management Fees: Property management fees are incurred by investors who choose to invest more passively. For a small percentage of the rent collected from a subject property, landlords may remove themselves from the equation. Nonetheless, transitioning to a primarily passive exit strategy will come at a cost that must be factored into the NOI.
- General Maintenance: Every rental property, especially older ones, will require at least some degree of maintenance. Whether it’s groundskeeping, plumbing, or electrical work, any maintenance conducted on the subject property must be accounted for in its NOI.
- Legal Fees: Whether ownership of a subject property leads to litigation or a landlord hires an attorney to draft a lease, the money spent on legal fees is no different from any other expense. Likewise, legal fees are an important variable in a traditional net operating income formula.
- Utilities Not Paid By Tenants: In the event the owner elects to pay some or all of the utilities, their expense will impact the real estate NOI. For example, any sewage or waste fees paid by the landlord must be deducted from the income generated to identify the property’s NOI.
- Property Taxes: Property taxes will vary from municipality to municipality, but they are nonetheless an important variable to factor into the NOI of a rental property.
- Insurance Costs: Money spent on insurance to cover the subject property must be included in the NOI, even if it’s only incurred once a year or biannually.
Is Mortgage Included In NOI?
Mortgage payments are not included in the net operating income formula for one simple reason: mortgage payments are not considered an operating expense. Again, net operating income, as its name suggests, accounts for an asset’s total income and subtracts vacancies and operating expenses. Therefore, mortgage payments are not included in the formula. Instead, real estate NOI equations will take ongoing costs required to run the property into consideration.
What Expenses Are Not Included In NOI?
When determining the net operating income, it is important to differentiate between costs that are unique to the property itself and costs that are specific to the investor. For example, when it comes to NOI, mortgage interest expenses will not be factored in. Here are other factors that would not be included when calculating net operating income:
- Mortgage Interest
- Income Taxes
- Debt Service
- Property Depreciation
- Tenant Improvements
- Repair For Wear And Tear
When To Use NOI In Real Estate
Net operating income is primarily used when determining profitability for commercial or residential rental property real estate investments. When considering potential deals, NOI can be utilized by both investors and lenders. By looking at this indicator, lenders can judge whether or not investors will make enough cash flow to make loan payments. It is not uncommon for NOI to be used when approving commercial loans for real estate investors. This is because lenders want to know whether or not investors will be able pay back the loan when considering the potential cash flow.
While NOI is thought to be a reliable indicator when determining the potential income of a property, it is not the only real estate calculation investors should keep handy. Investors should familiarize themselves with a number of formulas in order to analyze deals effectively.
Additionally, NOI can be used as a variable in other calculations designed to evaluate investments. When determining the capitalization rate of a property, investors will need to use the net operating income and the property value in order to determine the potential rate of return.
Pros & Cons Of Using NOI For Investment Properties
The net operating income formula has developed a reputation for serving investors well. However, it is worth noting that even a perfect NOI real estate equation has its flaws. There are both pros and cons to using this evaluation strategy, not the least of which include:
Pros Of Using NOI Formula
- The net operating income of a subject property can help investors determine an initial value.
- NOI real estate formulas award investors with an overview of what to expect from ongoing revenue.
- The real estate NOI value can help lenders determine whether or not the property represents a risky investment.
Cons Of Using NOI Formula
- Knowing how to calculate net operating income isn’t universal, and can change from investor to investor.
- Depending on how the asset is managed, the NOI may be inconsistent.
- If projected rents prove inaccurate, the NOI will be impacted negatively.
The right real estate calculations can provide investors with the ability to evaluate properties and make informed investment decisions. Now that you can answer the question “what is net operating income in real estate,” you should be more prepared to use the metric as you analyze deals. Remember, NOI real estate formulas can serve as a basis for evaluating potential properties, and can even be used in conjunction with other real estate calculations to help further analyze deals. By understanding NOI, investors will be better equipped to estimate the income of their potential deal and have success in real estate.