Real estate investors can calculate net operating income (NOI) as a measure of the potential cash flow that a property can generate. This metric is beneficial not only for investors but also for lenders.
NOI gives lenders a better understanding of an investor’s prospective return on investment and financial gain. Used to evaluate the performance of a property over time, NOI helps investors make better-informed decisions about whether or not to buy, sell, or hold a property.
What Is Net Operating Income (NOI)?
Net operating income (NOI) is a key metric used to determine the profitability of an individual investment property or portfolio of properties. NOI is the difference between a property’s gross operating income and operating expenses.
Real estate investors and lenders use NOI to assess if a property is worth investing in over time. Using this measure, they can compare different properties and see if one offers a higher return on investment.
Generally, when two properties yield different incomes but similar operating expenses, the higher NOI is usually the more profitable investment.
Why Is Net Operating Income Important to Investors?
NOI is crucial for determining a real estate investor’s debt service coverage ratio (DSCR). This ratio helps establish whether or not the borrower can repay their current debts with their income streams.
If the DSCR is low, it may be difficult for an investor to secure financing from a lender. While some lenders won’t approve a loan for a property with a low DSCR, some are willing to take the risk. Calculating the DSCR involves dividing NOI by the total annual debt.
NOI can also help an investor figure out the capitalization rate, a measure of a property’s valuation. A property’s cap rate reflects how much it is worth compared to other similar properties in the same area.
Using a cap rate can help gauge the profitability of commercial real estate or rental property. If the capitalization rate is high, the property may yield a high-income relative to the initial investment. The cap rate generally depends on several factors, including the market and the particular property.
Here are other reasons why investors place value on understanding a property’s NOI:
1. It’s a Good Indicator of Profitability
The bottom line for any investor is profit, and NOI is one of the best measures of profitability for a real estate investment. By comparing the NOIs of different properties, investors can quickly identify which ones are likely to be more profitable.
2. It’s a Predictor of Future Cash Flow
A property’s NOI is a fair indication of the cash flow it will generate in the future. This is important because cash flow determines an investment’s success or failure. An investment with strong future cash flow prospects is much more likely to be successful than one with weak cash flow prospects.
3. It Makes It Easy To Compare Properties
One of the challenges of investing in real estate is that there are many variables to consider when comparing properties. But by focusing on NOI, investors can efficiently compare properties with similar income and expense profiles.
4. It’s an Efficient Way To Value a Property
Property value is ultimately determined by its expected future cash flows. And NOI is one of the most effective predictors of potential income. As a result, by looking at a property’s NOI, investors can get a good sense of its market value.
How To Calculate Net Operating Income
To calculate NOI, start with a property’s total revenue in a year, then subtract any operating expenses incurred during that period. The income can come from the rent, laundry machines, parking fees, and vending machines.
On the other hand, total operating expenses may include items like property taxes, insurance, utilities, and repairs and maintenance. Plus, consider additional costs related to running the property, such as janitorial expenses and advertising fees.
Here’s a simple net operating income formula:
NOI = Property’s total annual revenue – Annual operating expenses
For example, a multifamily property generates $30,000 in annual income and has $5,000 in annual operating expenses. The NOI for this commercial property would be $25,000 after subtracting operating expenses from revenue.
Once you have calculated NOI, you can compare different properties or portfolios. It is also a helpful metric for figuring out if a property is meeting your investment goals. Note that NOI does not typically account for depreciation or mortgage interest.
What Factors Can Affect Net Operating Income?
When it comes to real estate investing, many factors could impact NOI. These considerations include:
- The property’s location: Properties in prime locations usually have higher NOIs than those in less desirable areas.
- The property’s age: Older properties tend to have lower NOIs than newer ones.
- The condition of the property: Properties in poor condition will typically have lower NOIs than those that are well-maintained.
Other vital factors involve vacancy and credit loss, which could potentially influence the metric. For example, if a property has vacant units or tenants who don’t pay their rent, it could reduce the NOI. In addition, operating expenses can include the cost of any utilities not covered by tenants, property management fees, or taxes and insurance.
How To Improve Your Net Operating Income
NOI is the difference between a property’s annual gross income and operating expenses. A property with a high NOI is usually seen as more profitable and attractive to real estate investors. There are a few ways an investor can improve their property’s NOI.
Among the most common approaches is to increase rental income. You can raise the rent or find new tenants willing to pay more. A property owner could reduce turnover and vacancy rates by implementing a resident retention program.
Another way is to decrease operating expenses by negotiating better deals with vendors and suppliers and improving the property’s energy efficiency. The latter can be achieved through simple upgrades like installing LED lighting or weatherstripping doors and windows.
An investor may also add value to their property by improving its market value and attracting tenants. Improvements could include upgrading the finishes or amenities.
What Is the Difference Between Net Operating Income and Profit?
NOI is a calculation that measures the profitability of an investment property before taxes and other expenses are taken into account. On the other hand, profit is the total revenue earned from an investment property after all costs have been paid.
To calculate NOI, you’ll need to consider your property’s gross income and subtract any operating expenses. Operating expenses can include things like insurance, repairs, and utilities. Once you’ve subtracted these costs from the gross income, you’ll have the net operating income.
To calculate profit, take the net operating income and subtract any non-operating expenses. Non-operating expenses can include interest payments on loans, depreciation, and amortization. Determine profit by subtracting these costs from the net operating income.
Bottom Line on Net Operating Income
Overall, understanding NOI is essential for real estate investors. It is a crucial metric to assess a property’s potential profitability, including its income and rate of return. In addition, NOI can show how much a property is worth after deducting operating expenses.
Operating expenses include all the costs associated with running and maintaining a property, such as insurance, taxes, utilities, repairs, and maintenance. These expenses are deducted from the property’s gross operating income to arrive at the NOI formula.
Investors can also use NOI to compare different properties side by side to see which one is more likely to be profitable. With a firm grasp of how to calculate NOI and what factors impact it, investors can make more informed investment decisions that will help them achieve their financial goals.