Net Operating Income (NOI)
Assess the profitability of revenue-generating real estate investments.
What Is Net Operating Income (NOI)?
The Net Operating Income (NOI) is measurement of net operating income is used to assess the profitability of income-generating real estate investments. It is calculated by subtracting all revenue from the property from all necessary running expenses.
This is a statistic on a property's income and cash flow statement that compromises:
- Principal and interest loan payments
- Capital spending
- Depreciation
- 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
Net Operating Income = (Gross Operating Income + Other Income) - Operating Expenses
Net Operating Income = Real Estate revenue - Operating expense
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.
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.
Key Takeaways
- NOI evaluates profitability of revenue-generating real estate by deducting expenses from revenue.
- Net Operating Income is akin to Earnings Before Interest and Taxes (EBIT) in other industries.
- NOI Calculation involves subtracting operating expenses from Gross Operating Income (GOI) and other income.
- Net Operating Income is vital for valuation, cap rate assessment, and loan repayment analysis in real estate.
How to calculate net operating income
To calculate it correctly, you must determine your Gross Operating Income (GOI). The formula for gross operating income is as follows :
Gross Operating Income = Potential Rental Income - Vacancy Rates
The different components of the formula are:
1. 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."
2. 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.
3. 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.
- Vending machines
- Second parking lot
- Coin laundry machine.
The parcel doesn't need to provide additional income for the business.
4. 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, 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
- Miscellaneous fees such as property management fees, accounting and attorney fees, and marketing costs
Calculation of net operating income
We will now understand how to work with the NOI formula with the help of an example.
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 of net operating income
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.
It is used in 3 ways:
1. Understanding Property Performance
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.
2. Analyzing Historical Trends
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.
3. Exploring Cap Rate and Rate of Return
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 = Net Operating Income / Market Value
Here are important factors to note about Cap rate and rate of return:
- Helps determine a property's market value and make a profitable investing or purchasing decision
- 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 = Net Operating Income / Annual debt
Some Related Terms
Profit margin is one of the most widely used profitability statistics to determine how profitable a firm or business activity is. It denotes the percentage of sales that have resulted in profits.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Sometimes, it is used as a substitute for net income to measure a company's overall financial performance.
Depreciation is an accounting word that refers to allocating the cost of a tangible or physical asset over its useful life. Depreciation is a term used to describe how much of an asset's worth has been used.
Amortization is a strategy used in accounting to lower the book value of intangible assets over a predetermined period. Amortization is a type of accounting disclosed on a company's financial statements.
A mortgage is a loan used to buy or maintain a home, land, or other real estate. The borrower agrees to repay the lender over time, usually in regular installments divided into principal and interest.
Net Operating Income (NOI) FAQs
It is a valuation method used by real estate owners to assess the profitability of revenue-generating real estate investments.
The formula for calculating it is:
Net Operating Income=(Gross Operating Income+ Other Income)- Operating Expenses
Gross operating income includes potential rental income and unit vacancy rate. It is calculated by the formula suggested below :
Gross Operating Income = Potential Rental Income - Vacancy Rates
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.
These is used to calculate capitalization rate, market value, debt service charge ratio, analysis, and evaluation trends and help make decisions based on NOI calculation.
The cap rate is the most often used metric for determining real estate investments' profitability and return potential.
The cap rate essentially shows a property's yield over a one-year time horizon, presuming the property was purchased with cash rather than a loan.
In commercial real estate, the capitalization rate (also known as cap rate) is used to express the projected rate of return on a real estate investment property.
Revenue less all operating expenses equals net operating income, whereas net income is revenue less all expenses, including managing and non-operating expenses like taxes.
Researched and authored by Abhinav Bhardwaj | LinkedIn
or Want to Sign up with your social account?