Table of Contents
- Understanding Net Operating Income (NOI)
- Key Takeaways on NOI
- What NOI Tells Real Estate Investors
- Formula and Example
- Profit and Loss
- How Does Net Operating Income Differ From Gross Operating Income?
- Is NOI Used in Other Industries or Sectors?
- What Is a Good Net Operating Income Percentage?
- The Bottom Line
Understanding Net Operating Income (NOI)
Let me explain to you how calculating net operating income (NOI) helps measure the profitability of an income-producing property. NOI shows the profitability of income-generating real estate investments. It includes all revenue from the property, minus necessary operating expenses. Remember, NOI is a before-income-tax figure on a property’s income and cash flow statement, excluding principal and interest payments on loans, capital expenditures, depreciation, and amortization.
Key Takeaways on NOI
Net operating income (NOI) measures an income-producing property’s profitability. To calculate NOI, subtract all operating expenses incurred on a property from all revenue generated. NOI helps a property owner determine if renting a property is worth the expense of owning and maintaining it.
What NOI Tells Real Estate Investors
NOI looks at the total revenue versus the total operating expenses of a rental property. Revenue comes from rent, parking or storage fees, and on-site vending machines or laundry services. Operating expenses include maintenance and repairs, property taxes and insurance, property management fees, janitorial services, and utilities. Capital expenditures, such as costs for a new air conditioning system for the entire building, are not included in NOI.
NOI is used to calculate the capitalization rate, a measure of an investment property's profitability relative to its total cost. The cap rate is calculated by dividing the NOI by the property's total cost. Expressed as a percentage, the capitalization rate helps investors compare the returns of different properties.
For financed properties, NOI is also used in the debt coverage ratio (DCR), which tells lenders and investors whether a property’s income covers its operating expenses and debt payments. NOI is also used to calculate the net income multiplier, cash return on investment, and total return on investment. Keep in mind that a property's capitalization rate is also known as return on investment (ROI) in real estate.
Formula and Example
The formula for net operating income is NOI = RR - OE, where RR is real estate revenue and OE is operating expenses.
Take this example of a rental condominium: Revenue includes rental income of $20,000, parking fees of $5,000, and laundry machines of $1,000, totaling $26,000. Operating expenses include property management fees of $1,000, property taxes of $5,000, repair and maintenance of $3,000, and insurance of $1,000, totaling $10,000. The net operating income (NOI) is $26,000 - $10,000 = $16,000.
Profit and Loss
An owner who collects $120,000 in revenues and incurs $80,000 in operating expenses will have a resulting NOI of $40,000 ($120,000 - $80,000). If the total is negative, with higher costs than revenues, the result is called a net operating loss (NOL).
Creditors and commercial lenders rely heavily on NOI to determine the income generation potential of a mortgaged property. NOI helps lenders forecast a property’s cash flows. If a property is profitable, the lenders also use this figure to determine the amount they are willing to lend. Lenders may reject a mortgage application if a property shows a net operating loss.
Property owners can manipulate operating expenses by deferring certain expenses while accelerating others. NOI can also be increased by raising rents and other fees while decreasing operating costs. If an apartment owner waives a tenant’s yearly $12,000 rent in exchange for that renter acting as a property manager, valued as a $30,000 cost, the owner may subtract the cost from the revenue.
How Does Net Operating Income Differ From Gross Operating Income?
Net operating income estimates the potential revenue from an investment property. However, it does not account for costs such as mortgage financing. NOI is different from gross operating income. Net operating income is gross operating income minus operating expenses.
Is NOI Used in Other Industries or Sectors?
NOI is used in other industries and referred to as EBIT, which means earnings before interest and taxes.
What Is a Good Net Operating Income Percentage?
NOI is not a percentage but a number that weighs the revenues against the expenses of a property. It can be compared to the property’s value as if it had been paid in cash. In this case, the higher the net operating income to property price percentage, the better.
The Bottom Line
Net operating income (NOI) can assess a property's profitability. The calculation involves subtracting all operating expenses on the property from all the revenue generated from the property. The higher the revenues and the smaller the costs, the more profitable a property is.
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