Investors use several metrics to evaluate the profitability and return of a real estate investment. One of the most important is net operating income, or NOI. When investing in income-producing properties, the investor must know how the property will perform after accounting for operational expenses.
The NOI can help determine the cash-on-cash return, yield, and even cap rate of a property. This article covers how to calculate NOI, why it’s important, and important things to know about using NOI in real estate.
The formula for calculating net operating income
Net operating income illustrates the annual income a property generates by adding up all annual income and subtracting all annual expenses.
NOI = (gross income generated from property x vacancy rate) - total expenses
Rental income includes all income collected for the property, which may include
- gross rents;
- late fees;
- retail sales in a storage facility, such as boxes, locks, or moving supplies;
- income from on-site laundry facilities in apartments;
- parking fees;
- service charges; and
- pet deposits or monthly pet fees.
Property expenses can include
- vacancy, accounting for the average rate of rent uncollected when units are vacant;
- real estate taxes;
- property insurance;
- management fees or manager salary;
- repairs and maintenance;
- utilities (including phone, internet, water, gas, electricity, and trash);
- lawn care and pest control;
- office supplies;
- advertising and marketing; and
- professional services, such as a bookkeeper, accountant, or legal fees.
The NOI doesn't account for debt services, such as a mortgage or a payment to a private lender, partner, or capital reserves.
Net operating income can be a negative or positive amount, indicating whether the property loses or makes money each year.
Most investors look for a positive NOI, although there are times when buying a property with a negative NOI makes sense -- like when an investor has the potential to add value by increasing rental rates or decreasing vacancy. These changes can result in a return to a positive NOI.
Why NOI is important in real estate
Knowing the net operating income of a cash-flowing property can help you determine its performance so it can be compared to other properties. The most common way this is done is through the cap rate, a metric used to determine a commercial property’s value. The lower the cap rate, the higher the cost of the property and the lower return for the buyer.
Net operating income can also help determine the debt service coverage ratio (DSCR). This is often used by lending institutions to determine whether there's sufficient income to support debt coverage.
Investors also use NOI to determine the overall yield or return of an investment. If an investment produces a $50,000 annual NOI and you bought it for $500,000 in cash, you'd have a 10% cash-on-cash return.
Important things to know about NOI
Investors manage and operate assets differently, meaning a seller’s NOI may differ greatly from yours. When a property is underperforming, it’s not uncommon to have two NOIs, one based on the actual performance and a pro forma NOI based on your projected income and expenses.
Many times, realtors or sellers will provide prospective buyers with an NOI that doesn’t account for the property's operating expenses. When evaluating an asset, perform your own due diligence on potential costs and expenses and verify income and vacancy rates. You need an accurate view of the property’s performance.
The net operating income is a critical part of evaluating an income-producing property. You now understand the role NOI plays in real estate investments and how to accurately calculate it. Use it to compare investment opportunities and review the overall performance and profitability of a real estate holding.