Net Operating Income (NOI): Definition And Formula
There are a handful of “tools” any real estate investor needs in their “tool belt”: solid knowledge of their preferred real estate market, the ability to estimate remodel costs, and a firm grasp on basic financial concepts. One of the most important calculations for real estate investors is knowing how to correctly calculate net operating income (NOI).
This powerful calculation enables real estate investors to make financial decisions at a glance.
What Is Net Operating Income (NOI)?
Net operating income, or NOI for short, is a formula people use to quickly calculate the profitability of a particular real estate investment. NOI determines the revenue and profitability of real estate property after subtracting necessary operating expenses.
The formula works by considering all income a property makes minus all of the general expenses. For example, a property may earn money from tenant rents and a coin laundry machine. However, operating expenses aren’t just maintenance fees, but include expenses like insurance and professional help.
The power of NOI is that it considers all of the necessary income and expenditures per property in one calculation.
The Net Operating Income Formula
The formula for NOI is as follows:
Net Operating Income = (Gross Operating Income + Other Income) − Operating Expenses
Below, we’ll walk through which numbers to include in your formula and how to calculate NOI.
How To Calculate Net Operating Income (NOI)
It can get confusing distinguishing between gross income and net income, especially as we break down the formulas below. Here are two things to remember:
- Gross income is what you make.
- Net income is what you take home.
Gross Operating Income
To accurately calculate NOI first, you need to calculate your gross operating income (GOI).
Gross Operating Income = Potential Rental Income − Vacancy Rates
It’s easy to fall into the trap of assuming that your gross income is simply what the property is worth. Unfortunately, this assumption is wrong. Gross operating income also needs to mathematically account for fluctuations in a property’s rental income.
It sounds tricky but it’s fairly simple to estimate. Here’s how to get to your true gross operating income.
Potential Rental Income From Rental Properties
Potential rental income (PRI) is how much you’d make if a rental property was 100% leased, 100% of the time. This is the number that’s easy to stumble on because investors often think in terms of “best case scenario,” but this number only represents potential income versus actual income.
Vacancy And Credit Losses
It would be great if a property was 100% leased, but it isn’t likely to happen every year. This is why GOI factors in vacancy and credit losses against potential rental income.
When evaluating the profitability of a potential real estate investment, use comparable property vacancy rates or ask the current owner for historical accounting to get a better idea of the vacancy percentage. Knowing the vacancy history of the rental property will make your calculations more accurate.
Remember, NOI takes into account all income, which is GOI plus any additional income a property makes. A property can make money outside of tenant rents in a variety of ways. For instance, maybe the property boasts vending machines, an additional parking lot or a coin laundry machine.
A property may make additional income, but additional cash flow isn’t a rule.
OK, now that we have an accounting of gross income, we need to add up operating expenses, which are what it actually costs to own the property. Operating expenses to include in your calculations are:
What Isn’t Included In Net Operating Income?
While it’s important to understand what is included in the meaning of NOI, it’s just as important to know what is not included. NOI does not include numbers that can be written off against future earnings and taxes. It also does not include large one-time costs such as major repairs.
Seem confusing? The purpose of NOI is to give investors a look into the true cash flow of a rental property: how profitable it is (or isn’t), how much it costs to maintain the property and the overall health of the investment.
Certain numbers are excluded from NOI calculations because they do not support the purpose of net operating income (NOI).
Because we’re looking at true cash flow with NOI, here’s what to exclude from your NOI calculation.
You may notice one big expense is missing from the list above: mortgage payments. This is because debts are not included in an NOI calculation since the amount of debt can vary from investor to investor.
One investor may be able to put 50% down, while another can only put 20%. This number would substantially influence NOI if included, but because we want to see the overall health of the property (and not the financials of a specific investor) we exclude this from our calculations.
Excluding debt allows us to compare properties on the same merit: income vs. outflow.
Debt Service Coverage Ratio (DSCR) is the measure of a property’s cash flow against what it needs to cover any loans.
Property Taxes and Income Taxes
NOI is a pre-tax calculation, which means all taxes are excluded from the formula. Tax expenses also vary widely by the investor, and since NOI is specific to the property, not the person, it’s not included in the formula for NOI.
Depreciation isn’t an actual expense because you never “pay” for depreciation out of pocket like with cash or check. Depreciation, rather, is an accounting concept. Depreciation only becomes “real money” when writing it off on your taxes or during the sale of a potential property.
Since NOI only looks at real, annual expenses that come out of cash earned each year, depreciation is also not included in the calculation.
Operating an investment property can be expensive, and yes, there will be years when more capital is required for maintenance. However, because this expense can vary widely year-to-year and property-to-property, you do not include large one-time expenses in an NOI calculation.
Also, it is extremely unlikely an investor would use cash flow for a large expense, such as paying for a new roof out of income from tenant rents. Often, investors use cash reserves (savings) to fund these expenditures and so it doesn’t make sense to account for both the extra expenses and cash in any NOI formula.
How To Calculate Net Operating Income
NOI is (typically) calculated on an annual basis. So, here’s an example of how to calculate NOI each year.
When you’re evaluating a potential investment property you’ll want to calculate the NOI before deciding to invest. For example, if you were considering buying a small, four-unit apartment complex, try doing the following calculation to evaluate your investment.
Each of the four units rents for $1,500 per month, making the potential rental income (PRI) $72,000 per year. Add in the coin laundry in the basement of the property, which makes $1,000 annually, for a total of $73,000 per year.
If vacancy losses are 10% (PRI ✕ .10) that would equal $7,200 per year. The total PRI ($72,000) minus the vacancy losses ($7,200) brings the gross operating income (GOI) down to $64,800.
Based on the current owner’s accounting you know that operating expenses are $15,000 each year.
So, your net operating income = (GOI [$64,800]) + (Other Income[$1,000]) − Operating Expenses [$15,000]
So, the Net Operating Income = $50,800 annually
Based on this NOI calculation, an investor can:
- Use this number to compare the investment’s income to other properties.
- Determine if the investment earns enough to cover any loans.
- Figure out the cap rate (total rate of return on investment).
- Calculate a property’s worth and a reasonable offer price.
How NOI Is Used To Determine Cap Rate
If you’re considering real estate investing, you’ve probably heard the term “cap rate.” NOI is also used to help determine the cap rate of an investment. The capitalization rate, or cap rate, is how investors quickly assess the potential for profitability in a particular investment.
You can think of “cap rate” as a synonym for return on investment (ROI), but it’s used more widely in the real estate sphere. When talking about these two terms in relation to each other the following formula applies:
Capitalization Rate = Net Operating Income ∕ Purchase Price
Let’s assume the four-unit property in the example above is listed with an asking price of $360,000. That would mean that the property has a cap rate of 14%.
Depending on how much an investor wants to earn on their investment, they can use the cap rate metric to vet potential investments. For example, 14% may be a good rate for one investor and less than ideal for another.
NOI is a helpful mathematical formula real estate investors can use to calculate how profitable a potential investment property is in a single year, by taking into account annual expenses.
It’s important to remember that NOI calculates income versus expenses at the property level, not at the investor level. So, monetary considerations will vary from person to person and aren’t included in the formula for NOI. NOI gives investors a good baseline to compare properties and incomes but should not be considered a direct comparison of all costs.
NOI is one quick method to assist investors in making good purchasing decisions on investment properties. If you’re considering purchasing a rental property start the mortgage approval process today.