Net Operating Income (NOI)

Assess the profitability of revenue-generating real estate investments

The measurement of net operating income is used to assess the profitability of revenue-generating real estate investments. It is calculated by subtracting all revenue from the property from all necessary running expenses.

Net Operating Income Noi

This is a statistic on a property's income and cash flow statement that compromises principal and interest loan payments, capital spending, depreciation, and amortization. 

This measure is also known as "EBIT" in other industries, which stands for "earnings before interest and taxes."

The formula takes a property's income and subtracts all its general expenses. For example, rent from tenants and a coin washing machine can help a property make money. 

Maintenance costs aren't the only thing to consider when it comes to operating costs; insurance and expert assistance are also essential considerations.

The strength of NOI is that it combines all the essential income and expenditures for each property into a single computation. The formula for net operating income is as follows :

FormulaFormula 2

The difference between "net" and "gross" is that gross income is an amount that a company makes, and net income is an amount the company takes home.

Calculating values

It is a valuation method used mainly by real estate investors and companies. Valuation is an essential element of finance as investments are made when considering it.

Gross operating income

To calculate it correctly, you must determine your Gross Operating Income (GOI). The formula for gross operating income is as follows :

Formula 3

Potential Rental Income - Also referred to as short form PRI, is the amount generated by a property when it is fully leased and for full time. This number is easily confused because investors often conclude it in the "best case scenario."

Calculator

Vacancy Rates

The vacancy rate refers to the proportion of all available units in a rental real estate, such as a resort or apartment building, that are vacant or unoccupied at any time.

A property with a high vacancy rate is not renting well, but a property with a low vacancy rate indicates excellent rental sales.

The vacancy rate is the inverse of the occupancy rate, which is the number of occupied units in a rental property.

Other Income

Remember that it includes all income, including GOI and any additional revenue generated by a property. 

Outside of tenant rents, a property might produce money in several ways. Perhaps the property has vending machines, a second parking lot, and a coin laundry machine. The parcel doesn't need to provide additional income for the business.

Operating Expense

An operating expense, also known as an operating expenditure, operational expense, operational expenditure, or open, is a cost incurred regularly to keep a product, business, or system running. 

On the opposite, a capital expenditure (CAPEX), on the other hand, is the expense of producing or procuring non-consumable pieces for a product or system.

Operational expenses included in the calculation are property taxes, insurance, maintenance/ repair cost, and miscellaneous fees such as property management fees, accounting and attorney fees, and marketing costs.

Calculation

We will now understand how to work with the NOI formula with the help of an example. 

Calculations

We are given,

Potential rental income = $5,000

Vacancy rate = 3%

Other Income = $3,000

Operating expense = $4,000

Step 1

First, we will be calculating gross operating income, 

For calculating GOI, we need potential rental income and vacancy rate.

As given, 

Potential rental income = $5,000

Vacancy rate = 3% = 0.03

The vacancy rate in terms of money,  

$5,000 x 3% = $150

GOI = potential rental income - vacancy rate 

GOI = $5,000 - $150 

GOI = $4850

Step 2

We need to calculate Net Operating Income from the information recorded above, 

NOI = (gross operating income + other income) - operating expenses

        = (4,850 + 3,000) - 4,000

        = $7,850 - 4,000 = $3,850

A positive net operating income states that a real estate's revenue is higher than its operating expenses. 

Uses

This valuation method is most commonly used in the real estate sector. The two potential influencing factors in it are rental income and expenses. Therefore, any increase or decrease will have a direct effect on NOI. 

Calculating values

It is used in the following ways: 

  • First, it helps the real estate owners understand the amount of money generated by their property and also helps in comparing two or more properties and identifying areas for improvement.
  • It is also used in analyzing trends and understanding and evaluating how real estate property has performed within the past few years. A constantly lowering NOI states that the property is not good enough for sale.
  • Capitalization Rate - also known as "cap rate," can be described as the rate of return from a property purchased in cash. For instance, the owner purchased a property for $3 million with an NOI value of $300,000, which makes a cap rate of 10%.

Cap rate and rate of return have a directly proportional relationship; any increase or decrease in cap rate will impact the rate of return. The formula for cap rate is 

Cap Rate formula

  • The formula for cap rate can also help determine a property's market value and make a profitable investing or purchasing decision. The procedure is hand and used for rough calculations based on fair values and comparing them with similar properties.
  • Debt service charge ratio (DSCR) - This is the ratio determining how little principal amount and interest the owner has to pay yearly to repay a loan. It can be formulated as dividing NOI by annual debt. The formula is listed below :

DSCR formula

Key Takeaways

Buildings

Net operating income is used to assess the profitability of revenue-generating real estate investments. This measure is also known as "EBIT" in other industries, which stands for "profits before interest and taxes."

Net Operating Income = Real Estate revenue-Operating expense

Gross Operating Income = Potential Rental Income - Vacancy Rates

  • Operational expense is a cost that is incurred regularly to keep a product, business, or system running.
  • It is used to calculate capitalization rate, market value, and debt service charge ratio, analyze and evaluate trends, and help make decisions based on NOI calculation. 
  • A cap rate can be described as the rate of return from a property purchased in cash. 

Cap Rate = Net Operating Income/ Market Value

  • Cap rate and rate of return have a directly proportional relationship; any increase or decrease in cap rate will impact the rate of return.
  • The debt service charge ratio determines how small the principal amount and interest the owner must pay yearly to repay a loan.

DSCR = Net Operating Income/ Annual debt 

FAQs

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Researched and authored by Abhinav Bhardwaj | LinkedIn

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