Net operating income (NOI) is a vital real estate profitability metric to help you calculate an investment property’s potential revenue. The NOI provides valuable data to determine whether to purchase a property, predict potential rental income, or raise rents to boost cash flow.
The NOI formula is straightforward. You deduct the operating expenses from the gross operating income (GOI) to calculate a property’s potential profitability. In other words, net operating income is the difference between how much the property costs to operate and the amount of revenue it generates.
Net operating income doesn’t use expenses like debt payments, mortgage payments, depreciation, or capital expenditures in the calculation. However, it helps you compare properties when buying or selling real estate. As a result, some investors consider this to be the most critical metric in real estate investing.
This article explains why NOI is important when making real estate investment decisions.
What Is Net Operating Income (NOI)?
Net operating income is an easy formula for calculating the potential rental revenue from an income-generating property. The formula uses two metrics — projected rental income and all expenses. The net operating income figure is a property’s total income minus the operating expenses.
How Net Operating Income (NOI) Relates to Real Estate
The beauty of using the NOI formula is that it’s a simple calculation to determine a property’s operating performance. Here is what it means in real estate terms:
- NOI and real estate investment: Calculating the difference between gross operating income and operating expenses is vital when evaluating different properties. You can easily estimate the revenue potential from single-family homes, condos, and multifamily properties. Putting the figures side-by-side helps you evaluate the best investment.
- NOI and your rental portfolio: The net operating income formula is also helpful in assessing the profitability of your current investments. For example, a simple analysis could show that the NOI has changed since you purchased the property. This could mean that you must start looking for ways to find additional revenue. Or you may decide to sell the rental unit due to revenue losses.
The net operating income formula is this:
Net Operating Income = Gross Operating Income – Operating Expenses
Here are some helpful explanations to help break down the formula:
- Gross: The total amount of revenue before deducting fees, expenses, taxes, or commissions.
- Net: Your “take home” amount after paying all related expenses.
Suppose the annual operating revenue from a single-family rental unit is $21,600. This is gross operating income. However, say that ongoing expenses amount to $4,800 annually. That means your net income after operating expenses is $16,800.
How to Figure Out Net Operating Income (NOI)
Although the NOI formula is straightforward, there are several variables you must consider to get an accurate picture of a property’s potential profitability. For example, you must allow for vacancy rates, all operating expenses, and additional income sources to figure out NOI. The calculation also includes potential income fluctuations.
Here are some of the variables to consider regarding expenses and income.
Gross Operating Income (GOI)
Ideally, you could calculate GOI as monthly rent multiplied by 12 to determine the gross annual income. However, it’s vital to remember that income can fluctuate depending on vacancy rates and potential sources of extra income. Also, you face the real possibility of a tenant not paying rent.
Here are factors to consider when working out gross operating income:
- Vacancy rates: An empty rental unit affects your potential cash flow. Therefore, factor vacancy rates using metrics from comparable properties or information from the current rental property owner.
- Credit loss: It’s wise to factor in occasions when a tenant doesn’t pay their rent. Like financial loss through vacancies, credit loss impacts your bottom line.
- Additional income: Does the condo or multifamily property have additional sources of income? Here are some examples:
- Venning machines
- Laundry services like a coin laundry machine
- Parking fees
Related: How to increase rental income.
It is important not to confuse income with cash flow. Therefore, knowing which expenditures to include and which to omit in the net operating income formula is vital.
Here are the operating and non-operating expenses included in the NOI calculation:
- Property maintenance and repair costs
- Landlord insurance
- Property management fees
- Other landlord-related expenses like accounting and attorney fees
- Property taxes
Because NOI is used to assess a property’s ongoing revenue, capital expenditures are not included. Therefore, you do not have the following capital expenses:
- Income taxes
- Property depreciation
- Capital expenditures like installing a new roof
- Property depreciation
- Mortgage payments
Why are mortgage payments excluded from operating expenses? After all, paying a mortgage may be your largest monthly expenditure. This is because mortgage payments depend on individual investors, not the property’s overall health.
Net Operating Income vs. Gross Operating Income
The difference between net operating income (NOI) and gross operating income (GOI) is how expenses affect the outcome.
Gross operating income is the potential total income from a property, considering vacancy and credit losses. It’s also vital to include additional income sources not included in rent.
Net operating income is the revenue when day-to-day expenses and fees are considered. NOI is the amount of cash you have left over after the costs of owing the rental property are deducted.
Net Income vs. Operating Income?
The primary difference between net operating income and net income is the type of expenses included. The operating income only refers to the revenue minus the day-to-day running costs of owning a rental property. Net income is your bottom line. It factors all debts, mortgage payments, operating costs, and additional income streams.
In short — operating income is the rental property’s profitability and is the most important metric when comparing individual investment properties.
Examples of Net Operating Income
Net operating income measures the potential income stream from real estate investments. Typically, you calculate the figure annually because of variations in month-to-month income and expenditure.
Here is an example of calculating NOI using the formula “GOI – Operating Expenses = NOI.”
Let’s say you are considering an investment property — a small multifamily property with five rental units. Here are some figures:
- Monthly rent for each unit — $1,600
- Potential annual rental income — $96,000 ($1,600 x 5 x 12)
- Annual income from the coin laundry machine — $1,200
We must also factor in vacancy losses to figure out a realistic GOI. The average is 10% for the area. The calculation is $96,000 x 10% = $9,600. Therefore, our Gross Operating Income is:
- $87,600 ($96,000 + $1,200 – $9,600)
The current owner’s accounts show that annual property expenses for the previous year were $16,500.
Here is our Net Operating Income calculation:
- $87,600 – $16,500 = $71,100
This real estate metric can compare the property with other potential investments. Additionally, you can work out if you can cover your mortgage payments and calculate the property’s value.
The NOI calculation also helps you ascertain the total return on investment — the capitalization rate.
NOI and Capitalization Rate
The net operating income calculation helps determine other metrics like the capitalization rate. Also called cap rate enables you to decide on your potential return on investment (ROI).
Here is how to use NOI and the Cap Rate formula:
Capitalization rate = Net operating income ÷ purchase price
For example, let’s say that the five-unit property in our example has a listing price of $460,000. Then, we can use the cap rate formula to calculate the rate of return on investment.
- $71,100 ÷ $460,000 = 15%
Therefore, you can use NOI and capitalization rate to determine your annual return and if the investment is solid.
Related: How to calculate cap rate.
What is an Ideal Net Operating Income Percentage?
A common question in real estate investing is what is the best NOI percentage? Net operating income is not expressed as a percentage. Instead, it is a number you get when deducting operating expenses from gross operating income.
Most investors use loans or finance for real estate investing. Therefore, it’s necessary to factor in the cost of financing when assessing properties, calculating the cap rate, and working out your business cash flow.
Generally, it would be best to look for properties with higher net operating income figures when compared to the property price. Most real estate investors agree that margins and operating incomes should be above 15% of the investment cost.
Calculating net operating income is invaluable when comparing real estate investments. And the good news is that NOI is easy to calculate and helps you quickly identify potential profitable investments. A higher NOI usually indicates a better investment opportunity.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.