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Investor's Guide of Net Operating Income (NOI)

Investor's Guide of Net Operating Income (NOI)

Net operating income is a measure of revenues vs operating expenses for real estate properties. Real estate investors need to understand and be able to calculate net operating income to properly evaluate investments.

The following article explains the definition and formula for net operating income and explores an example and application of net operating income.

Key Takeaways

  1. Net Operating Income is a calculation to determine the ability to generate a profit from operations of a real estate property
  2. Net Operating Income formula subtracts operating expenses from the total revenues generated by a property
  3. Net Operating Income is a tool for comparison of similar property types

What is Net Operating Income (NOI)?

Net operating income, also known as NOI, is a calculation to determine the profitability of a real estate property. Net operating income compares the income generated with the cost of maintaining and operating the property.

The net operating income formula is:

Net Operating Income (NOI)=RevenuesOperating ExpensesNet\space Operating\space Income \space(NOI) = Revenues - Operating \space Expenses

Revenues

Revenues represent the total income the property generates. The revenues from net operating income can be broken down into effective rental income and other income.

Effective Rental Income

The main source of revenue for commercial real estate stems from rentals. To determine the income from rentals, the effective rental income must be calculated, which accounts for the number of vacancies in the property. Effective rental income subtracts the vacancy rates from the potential rental income, represented as:

Effective Rental Income=Potential Rental IncomeVacancy RatesEffective\space Rental\space Income = Potential\space Rental \space Income - Vacancy \space Rates

Vacancy rate or rate of default is the rent not received due to vacancy or a tenant moving out. The average vacancy rate for properties in the U.S. runs around 5.6%. The value of the vacancy rate can be determined by asking brokers or researching similar properties.

Potential rental income represents the total rental income without any vacancies, which can be taken from the previous owner's rent roll, a document that shows rents that are due and received by the landlord.

Other Income

Other income comes from any alternate income-producing source for the property such as amenities, parking fees, vending machines, and coin laundry. Other income can be determined through the past owner's financial statements.

Operating Expenses

Operating expenses represent the cost of maintaining and collecting revenues for a property. The expenses include property taxes, utilities and repair costs, insurance, and fees from legal, accounting, or maintenance.

What does Net Operating Income (NOI) Not Include?

Net operating income determines the true cash flow of the property without including investor based expenses and one-time costs. Net operating income excludes:

TermDefinitionReason for Exclusion from NOI
DepreciationAccounting rule of long-term assets losing value over-timeDoes not affect cash flows of property
Mortgage PaymentsPayments required to pay back loanVaries depending on loan not property
Capital ExpendituresLarge one-time repairs or upgrades to propertyDepends on year and financing
Income TaxesTax on income generated by businessDetermine on investor basis

How to Find Net Operating Income (NOI)?

Let's look at an example of computing net operating income. Net operating income usually is calculated on an annual basis.

Assume we are looking to buy a building with 12 apartments and a parking lot. Based on the previous owner's financial statements, the rent rate for each apartment is $1,000 per month, the parking lot generates $2,000 per year, and maintenance and operating costs are $20,000 per year. We found the vacancy rate for a similar building in the area is 10%.

First, we need to calculate the potential rental income, which is the going rate for each apartment multiplied by the number of apartments and converted to annual basis multiply by 12. This calculation looks like:

Potential Rental Income=Rental Rate per MonthNumber of ApartmentsMonths per Year=$1,0001212=$144,000Potential \space Rental \space Income = Rental\space Rate \space per \space Month * Number\space of \space Apartments * Months\space per\space Year = \$ 1,000 * 12 * 12 = \$ 144,000

Now, we need to determine the effective rental income by subtracting the potential rental income by vacancy rate. Vacancy rate is given as a percentage of the potential rental income. The calculation looks like:

Effective Rental Income=Potential Rental IncomeVacancy Rate=Potential Rental Income(10%Potential Rental Income)=$144,00010%$144,000=$129,600Effective\space Rental \space Income = Potential \space Rental \space Income - Vacancy\space Rate = Potential\space Rental\space Income - (10\%*Potential \space Rental\space Income) = \$144,000 - 10\% * \$144,000 = \$129,600

Finally, we can figure out net operating income by subtracting operating expenses from effective rental income summed with other income, which is shown below:

Net Operating Income=RevenuesOperating Expenses=(Effective Rental Income+Other Income)Operating Expenses=($129,600+$2,000)$20,000=$111,600Net \space Operating \space Income = Revenues - Operating\space Expenses = (Effective\space Rental \space Income + Other \space Income) - Operating \space Expenses = (\$129,600 + \$2,000) - \$20,000 = \$111,600

With a net operating income of $111,600, the apartment building appears to be profitable and a worthy investment. However, we should utilize other financial metrics and analyses before purchasing this property.

What is the Use of Net Operating Income (NOI)?

Net operating income can be beneficial in understanding the potential profit of a real estate investment. As such, net operating income can be calculated to a negative number, called net operating loss. A net operating loss should be a cause of concern for investors.

Net operating income evaluates properties based on performance rather than an investor basis, which proves useful in comparative analysis of properties. Following the changes in net operating income over multiple years can indicate the increase or decrease in the performance of a property.

Other financial comparison metrics such as cap rates, debt service coverage ratio, and cash-on-cash return on investment utilize net operating income in their formulas.

Lenders use the magnitude of net operating income to determine the size of a loan. The calculation of property value divides net operating income by cap rate, which lenders implement to decide the issuance of loans.

What are the Drawbacks of Net Operating Income (NOI)?

Net operating income is a pre-tax figure that represents the cash flows of a property. However, the calculation of net operating income can be influenced by the previous owner's actions and geographic location of the property.

The past owner's decisions for maintenance, rental rates, and amenity fees heavily affect net operating income. For instance, if the previous owner mishandled maintenance of the property, the operating expenses could be high, which drives net operating income down. Additionally, the bad maintenance could result in high vacancy rates due to the lower living conditions, which forces net operating income lower.

On the other hand, a property owner could perform all the maintenance and operating expenses themselves, causing the operating expenses to be low and pushing net operating income higher.

When utilizing net operating income in comparative analysis of similar property types, accounting for property location matters due to the variance in property taxes. For example, the property tax rates in Chicago are around 1.55% compared to 0.88% in New York City, which could push net operating income lower for a Chicago property.

The location effect on property taxes holds similar to rental rates, in which different markets have varying average market rates.

Important Fact: To determine net operating income, an investor must take into account all the factors afflicting revenues and operating expenses of a property.

What are Net Operating Income (NOI) FAQs?

Net Operating Income vs EBITDA

Net operating income and earnings before interests, taxes, depreciation, and amortization (EBITDA) hold similar calculations for profitability, but net operating income accounts for vacancies in revenues. EBITDA applies to companies whereas net operating income pertains to commercial and non-commercial real estate properties.

Net Operating Income vs Net Income

Net operating income takes revenues minus operating expenses whereas net income subtracts operating and non-operating expenses from revenues. Non-operating expenses include costs such as capital expenditures and income taxes, which are excluded from net operating income. Revenues are calculated in the same manner as net operating income for net income.

Levered Net Operating Income

Net operating income is an un-levered metric as the loan and mortgage payments for an investor hold no effect on net operating income.

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