As a real estate investor, it’s important to know whether the investment property you’re purchasing is profitable, and if so, by what measure. Several metrics allow real estate investors to calculate the profitability of a commercial real estate investment, none more critical than the Net Operating Income.
Net Operating Income, or NOI, is a calculation used to determine the profitability of an investment property. More specifically, NOI is used to determine the total revenue and profitability of the property after all operating expenses have been deducted. Let’s delve deeper into how the Net Operating Income is calculated and when it’s most valuable.
The Net Operating Income tells investors how much money they’ll make annually from a commercial or residential rental property investment. It’s a high-level number primarily used to judge whether an income-generating property can provide positive cash flow. For this reason, the NOI is not just used by investors but also by lenders to evaluate whether investors will have enough cash flow to make loan payments.
The NOI is a valuable number because it’s unaffected by how you finance a real estate property, which allows for a more objective comparison. The flip side to that, however, is that because you’re not including the cost of financing the property, you will need to look at other metrics to get a complete picture. Here are a few pros and cons of using the NOI.
- The real estate NOI value provides an excellent high-level insight into what investors can expect in terms of ongoing revenue.
- Lenders can use the NOI to see if a commercial property will be a good investment.
- The NOI value depends highly on whether the property is being managed well.
- Rents must be estimated accurately for the NOI to indicate the property’s profitability correctly.
The Net Operating Income formula is as follows:
NOI = Income Generated from Property – Operating Expenses
The NOI calculation has two components: Income Generated from Property and Operating Expenses. Let’s talk about each.
Income generated from property
It’s easy to forget that rental income is not the only potential income generated from a property. To calculate an accurate NOI, you want to include all property income in your calculations and subtract any potential vacancies. You’ll need to look at the following:
- Gross Operating Income (GOI): The Gross Operating Income is calculated by taking your Potential Rental Income and subtracting Vacancy Rates from it to get an accurate annual income estimate. Your Potential Rental Income (PRI) is the income you’d have from a property if it were leased 100% of the time, and the Vacancy Rate is the average loss you’d incur when the property is unoccupied based on market data.
- Other income: You may have additional revenue from the potential investment property. This includes parking fees, laundry machines, vending machines, or other service fees associated with renting the units. Not all properties will have this additional income, but for those that do, it’s essential to include this in your calculations.
As with income, it’s important to add up all the expenses for a potential property so that you can know how much it costs to own the property and arrive at an accurate NOI number. Some operating expenses that you’ll want to include:
- Maintenance and repair costs
- Property management fees
- Property taxes
- Insurance costs
- Legal, accounting, and marketing costs
- Utilities paid for by the landlord
What’s not included
In addition to considering what you need to include in the total operating expenses, you’ll also need to know what to exclude. Here are some costs that aren’t included in an NOI calculation:
- Debt service or mortgage payments: Since the NOI or Net Operating Income only considers the ongoing expenses required to run a property, and mortgage payments are not considered operating expenses, they are excluded from the NOI calculations. The same rule applies to mortgage interest payments.
- Income taxes: Much like debt service, the income taxes are specific to the investor and, as such, excluded from the NOI calculation. It’s also important to remember that the NOI is a pre-tax figure and appears on a property’s income statement. It excludes principal and interest payments on loans, capital expenditures, depreciation, and amortization. Outside of real estate, the NOI is referred to as EBIT, which stands for earnings before interest and taxes.
- Depreciation: The NOI only considers actual expenses that come out in cash each year. Since depreciation is an accounting concept that is never really paid for in cash, it isn’t included in the NOI.
- Tenant improvements: If you’re doing any construction or modifications in a property specific to the tenant and not the property, they don’t count in the NOI accounting.
- Capital expenditures: Again, while capital expenditure is a significant expense, it varies yearly and from property to property. It is considered an upgrade rather than an operating cost and is therefore not accounted for in the NOI formula. Reserves for replacement, funds set aside for major future maintenance items, are also meant to be excluded from the NOI. However, opinions are divided on this, and, in practice, many investors will include reserves for replacement in their NOI calculations.
What is a good NOI?
The Net Operating Income (NOI) is a number, not a percentage, and given that it reflects the profitability of an investment property, the higher this number is, the better. To understand the value of the NOI, consider that the purpose of the NOI is to give you an accurate picture of a property’s potential cash flow. The NOI helps you see how well a property is being managed and can be used as a comparison metric with other comparable properties in the area.
The NOI can also, over time, give you an idea of how well your property is doing. If the NOI is continuously dropping, that may indicate that it’s either being mismanaged or lacking the profitability you seek, which means you need to fix the problem or consider selling.
How to improve NOI
To maximize your NOI means to increase your profit, which ultimately means more money in your pocket. There are a few ways in which this can be possible:
- Increase rental income: There are only a few critical variables in the NOI, and modifying any of them changes the NOI. The key among these variables is rental income. However, while it can be tempting to raise the rental income to boost your bottom line, know that it’s not always practical, especially if you’re already charging market rates. Increasing your rent can bring in more each month, but if you raise it too high, you could also increase your vacancy rate, which negates the gains in the NOI. Further, some states have rent caps that can limit your annual rent increases. That said, it’s a good idea to raise rents routinely to account for inflation and the cost of living.
- Decrease vacancy: While it’s inevitable that you will have some vacancy in your property, the lower the rate, the better your NOI. Long-term leases are the best way to lower your vacancy rates, as are speedier move-in timelines, better marketing, and signing incentives for new tenants.
- Minimize operating expenses: One of the most important numbers in the NOI calculation is the operating expenses, and if you can lower that number, your NOI starts looking better. Most operating expenses are inevitable, but it can be valuable for a real estate investor to look through the books regularly to see if there are cuts to be made or any extraneous expenses that can be trimmed. For instance, can you decrease the cost of utilities by using more energy-efficient alternatives? Or perhaps renegotiate with the property management company?
- Look for extra income: Are there any additional income sources for the property that you haven’t considered that could increase the operating profit? For instance, paid parking, apartment amenities, and laundry can all add up.
Calculations that use NOI
The NOI on its own is a valuable metric for calculating the profit potential of a real estate investment. But it can be helpful in the calculation of other metrics, too. Here are some of the metrics that use the NOI in their calculations:
- Capitalization Rate: The capitalization rate or cap rate calculates the rate of return on a real estate investment property.
- Cap Rate = (NOI / Current Market Value) x 100
- Debt-Service Coverage Ratio (DSCR): The DSCR is a metric that lenders typically use to determine whether the cash flow of a property is enough to cover its operating expenses and mortgage payments.
- DSCR = NOI / Total Debt Owed (mortgage + interest expense)
- Return on Investment: The ROI helps property owners determine a property’s investment potential.
- ROI = (NOI / Purchase price of the property) x 100
- Cash on Cash Returns: This metric looks at how much money a property makes compared to how much it costs to purchase the property.
- Cash-on-cash Returns = (NOI – Annual mortgage payments) / Cash invested
The bottom line
Net Operating Income (NOI) is a mathematical formula used to assess the profitability of a real estate investment. Still, like all real estate formulas, it should be combined with other metrics to provide a complete picture. Calculated correctly, the NOI can help investors make smarter purchasing decisions and indicate whether a property is being managed correctly once bought.
While buying properties outright is a fantastic way to grow your real estate investment portfolio, there is more than one way to invest in rental real estate. You can quickly and easily purchase shares in select rental properties through the Arrived platform and start making rental income immediately without a substantial down payment or cash investment. To find out more or get started, browse through our available properties.