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 those in real estate use to quickly calculate profitability of a particular investment. NOI determines the revenue and profitability of invested real estate property after subtracting necessary operating expenses.
The formula works by succinctly 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. Operating expenses aren’t just maintenance fees, but also things like insurance and professional help.
The power of NOI is that it takes into consideration all of the necessary income and expenditures per property into 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 all the numbers to include in your formula and how to calculate NOI.
How To Calculate Net Operating Income
It can get confusing distinguishing between “gross profit” and “net profit,” especially as we break down the formulas below. Here are two things to remember:
- “Gross” is what you make.
- “Net” 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. This is false. Gross operating income also mathematically accounts for possibilities and fluctuations in a property’s income.
It sounds tricky but it actually isn’t. Here’s how to get to your true gross operating income.
Potential Rental Income
Potential rental income (PRI) is how much you’d make if the 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.”
Vacancy And Credit Losses
It would be great if a property was 100% leased, but this isn’t likely each year. This is why GOI factors in vacancy and credit losses against potential rental income.
When evaluating a potential investment, use comparable property vacancy rates or ask the current owner for historical accounting in order to get a better idea of the vacancy percentage you should use to come up with your calculations.
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, the aforementioned coin laundry.
A property may make additional income, but not always.
OK, now that we have an accounting of gross income, we need to add up operating expenses: what it actually costs to own the property. Operating expenses to include in your calculations are:
- Property taxes
- Maintenance/Repair Costs
- Miscellaneous Fees: property management fees, accounting and attorney fees, marketing costs.
What Isn’t Included In Net Operating Income?
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? Certain numbers are excluded from NOI calculations because they do not support the purpose of net operating income (NOI).
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.
Because we’re looking at true cash flow with NOI, here is 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 a 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. DSCR does take into account NOI, and you can get a quick accounting of DSCR by using the following formula.
NOI/Total P+I each year = DSCR
NOI is a pre-tax calculation, which means all taxes are excluded from the formula. Tax expenses also vary widely by investor, and since NOI is specific to the property, not the person, do not include it.
Depreciation isn’t an actual expense because you never “pay” for depreciation out of pocket like with a 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.
Tenant Improvements (TI)
Because tenant improvements are specific to the tenant, and not the property as a whole, this cost also gets excluded from any NOI accounting.
Operating an investment property can be expensive, and yes, there will be years where more capital is required for maintenance. However, because this expense can vary widely year-to-year and property-to-property, we do not include large one-time expenses in a NOI calculation.
Also, it is extremely unlikely an investor would “cash flow” 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.
An Example Of How To Calculate NOI
NOI is (typically) calculated on an annual basis. So, here’s an example of how to calculate NOI out in the wild.
Imagine you are evaluating a potential investment property: a small, four-unit apartment complex. Each unit rents for $1,500 per month, making the Potential Rental Income (PRI) $72,000 per year. The coin laundry in the basement of the property makes $1,000 annually.
Vacancy losses are 10% (PRI x .10), or $7,200 per year. This brings the Gross Operating Income (GOI) to $64,800. Based on the current owner’s accounting, operating expenses are $15,000 each year.
Net Operating Income = (Gross Operating Income [$64,800]) + (Other Income[$1,000]) - Operating Expenses [$15,000]
Net Operating Income = $50,800 annually
Based on this NOI calculation an investor can then:
- Use this number to compare the investments income to other properties
- Ascertain 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 how much to offer for purchase
How NOI Is Used To Determine Cap Rate
If you’re journeying down the road of real estate investing, you’ve probably heard the term “cap rate” used frequently. NOI is also used to help determine the cap rate of an investment. The capitalization rate (a k a 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 widely in the real estate sphere.
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. Using simple math, we’d then determine 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 for potential investments. Now, 14% may be suitable for one investor and subpar for another.
To summarize, here are the most important things to know about NOI:
- NOI is a mathematical formula used to calculate how profitable a potential investment property is in a single year by subtracting total annual expenses from income.
- Do not forget to include vacancy rates in your Gross Operating Income (GOI) calculations as this will give a clearer picture of what a property can reasonably return in a year.
- NOI calculates income vs. expenses at the property level, not at the investor level. This means expenses and considerations that would vary from person to person are not included and investors can compare “apples to apples” (so to speak) when researching different properties.
- There are many things left out of an NOI calculation: debt, taxes, large expenditures (like new roof or HVAC), tenant improvements and depreciation.
NOI is just one quick method to assist investors making purchasing decisions, but there is more than one way to get started investing in real estate. If rental properties seem too cumbersome or capital intensive, investigate options such as Real Estate Investment Trusts or small-scale house flips. For answers to more questions about real estate, explore the robust Quicken Loans® Learning Center.