Some people buy property for their own personal use. Others, however, buy real estate as an investment. Net operating income is a measure of a real estate investment's profitability. To calculate net operating income, or NOI, we take the property's revenue, and subtract all reasonable operating expenses.
Understanding net operating income
Net operating income is a stronger indicator as to whether a real-estate investment is profitable, or has the potential to be profitable. NOI is reported on income and cash flow statements, and examines the cash flows of an investment property before factors like financing costs and taxes are taken into the equation.
If a property's total revenue over a given period is $200,000, and its operating expenses equal $100,000, then its net operating income is $100,000. Ideally, a property's net operating income should be positive. If the total is negative, it becomes a net operating loss.
There are several ways for a property to generate revenue. These include:
- Monthly rent payments from tenants
- Common area rentals from tenants or outside individuals
- Proceeds from on-site laundry facilities
- Proceeds from on-site vending machines
- Proceeds from on-site parking facilities
Similarly, there are numerous operating expenses that go into running a property. These include:
- Routine maintenance costs, such as lawn care and snow removal
- Property repair costs
- Superintendent, doorman, and office staff salaries
- Property management fees
- Janitorial expenses
- Real estate taxes
- Utility costs not directly passed on to tenants
Uses of net operating income
Net operating income is a strong measure of a property's ability to generate income. The NOI calculation excludes figures such as income taxes or financing costs. Rather, it shows how much revenue a given property can generate on its own.
Net operating income is considered an accurate measure of a property's potential because it is less subject to manipulation than other figures. NOI can typically only be increased by raising rents, increasing the cost to use on-site facilities like laundry and parking, or finding lower-cost options for maintenance and repairs.
Net operating income is essential in helping investors determine a property's capitalization rate, which is the rate of return on an investment property based on the income that it's expected to generate. As such, NOI can help an investor compare different properties to see which has the most potential. It can also be useful for an investor who owns several properties and is looking to unload the one whose operating costs leave the least amount of room for profit.
Net operating income also comes into play when properties need to be financed. Specifically, NOI is used to calculate a property's debt coverage ratio, which measures its ability to pay its debt based on its cash flow. Since NOI shows how much income a property can generate based on how much it costs to keep it running, it's a helpful tool for lenders and investors alike.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center, in general, or this page, in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!