Net operating income (or NOI) is one of the most important tools that real estate investors use to determine the strength of their investment. Ultimately, it shows the profitability and value of a piece of investment real estate.
NOI is a calculation that measures how much cash flow an investment property generates for you after you deduct your operating expenses, but before deducting any interest and principal payments, depreciation, capital expenditures and amortization. NOI is one of the most commonly-used metrics real estate investors use to determine whether a property would make a good investment.
What NOI does is allow investors to determine whether they are charging enough for rent, whether they need to control their expenses better or if the property just simply won’t cut it as an investment. Calculating NOI is easy, and there are a lot of practical uses for it.
In order to calculate NOI, you need to know four main pieces of information:
- Rental income
- Other income
- Total operating expenses
To calculate NOI, you simply add your rental income and your other income, and then subtract both your losses from vacancies and your total operating expenses. All of these stats should be annualized, so if you have your monthly totals, simply multiply them by 12.
Easy enough, right? Before you can properly calculate NOI, though, you need to have a better understanding of each of these data points.
1. Rental income
If you already own the property and are renting it out, then you know what your actual rental income is. It’s easy to figure out that your annual rental income is $12,000 if your actual rent is $1,000 per month. This becomes a little more complicated if you don’t already own the property, though. In fact, real estate investors will often want to know what the NOI of a property is to determine whether it’s a good property to buy.
In this case, rental income gets substituted for potential rental income. To do this, you’ll want to search comparable rental properties in the area and factor in things such as improvements you would do to the property if you purchased it. There are plenty of online tools available for this, but one of the best is HomeUnion®’s RENTestimate.
2. Other income
There are a number of items that could fall under this category. If you own an apartment building, for example, other income could include revenue from laundry services or vending machines. If you own a single-family home, you may charge parking fees if the town requires permits. It’s possible, though, that you have no income other than your monthly rent.
Vacancy is an important piece of information you need to factor into your NOI. Vacancy, in these terms, occurs whenever your property is empty because an old tenant moved out, or when a tenant doesn’t make their rent payments. Whatever income you would have generated in those months is what makes up your vacancy losses.
If you own a property already, this is easy to calculate, because you’ll know when your property was vacant. If you are searching for a property to invest in, a good suggestion is to factor in a 10 percent vacancy loss, just to be safe. This means if your annual potential rental income is $12,000, your vacancy losses would be $1,200.
4. Total operating expenses
The total operating expenses are all the costs associated with maintaining your rental property. Since NOI is a calculation for each property itself, total operating expenses here do not take into consideration any fees associated with how you might choose to purchase the property.
For example, if you took out a mortgage to finance the purchase, you would not count your mortgage insurance and principal into your total operating expenses. You also don’t count income taxes you’ll have to pay, leasing commissions, depreciation, normal wear-and-tear repairs and any other debt service you owe.
That leaves five general items that factor into your total operating expenses:
- Property insurance: This is to protect your investment in case of damage from Mother Nature, as well as other loss of income events.
- Property taxes: These are assessed and determined by your location as well as the value and size of your property.
- Management fees: If you hire an outside management company to maintain the property, you will have monthly management fees. These fees can be about 8 percent of the gross rent you collect each month for annual rentals.
- Maintenance and repairs: A good estimate is to factor in costs of about 1 percent of the value of your property for annual maintenance and repairs. Here, you’re counting things such as painting, lawn care, pest control and other repairs.
- Other expenses: Other expenses you want to account for are any marketing costs associated with trying to get a tenant, legal fees and any other expense that hasn’t been accounted for already.
How to Use NOI
Now that you know how NOI is calculated, how and when should you use it? In general, NOI is used two ways:
- Before you purchase a property – to determine whether a property may be a good investment
- After you purchase a property – to analyze cash flow and see if rent needs to be adjusted or costs need to be controlled
Let’s use an example to get a better sense of the practical applications of NOI. For both scenarios, let’s assume the following data points …
- Rental income (actual and potential): $24,000 annually ($2,000 per month)
- Additional income: $0
- Vacancy: $2,400
- Operating expenses: $4,800
In this case, the NOI on the property would be $16,800, figured out this way:
- $24,000 + $0 – $2,400 – $4,800
Before you purchase, you can use NOI to compare one property to many others. If the $16,800 number is higher than that of other homes in the market, then it’s probably a better investment than the others – no matter what the list price of the properties. Conversely, if it’s lower, there may be better investments out there.
If you already own the property, you can use NOI to analyze your investment and make changes if needed. If the NOI is too low for your liking, you have the power to pull a few levers to affect the outcome. This may include:
- Charging more rent, if the market supports it
- Generating other income, such as increased charges for pets or by offering cleaning services
- Reducing vacancy, by offering longer-term leases
- Minimizing expenses, by shopping around for property insurance or property management companies
In this way, NOI can be an extremely powerful tool, whether you’re looking to buy an investment property or own one already.
NOI is an important metric for other companies, too. Real estate investors who wish to get a loan to purchase an investment property will often have to provide an NOI calculation to lenders from whom they seek financing. This allows the lenders to analyze whether the money they are extending is a wise investment for them.
Why You Shouldn’t Use NOI
Despite all the positives listed above, there are reasons why some real estate investors don’t like NOI. Or, rather, they don’t like using just NOI to assess a property’s investment potential. There are a number of reasons for this.
- The NOI of a property is constantly changing. In fact, it can be dramatically different from one year to the next based off small changes such as how a property is maintained. NOI in this case doesn’t give a great overall assessment of a property’s long-term potential.
- NOI doesn’t take into account all expenses. If you are financing the property with a mortgage, for example, NOI doesn’t account for your monthly principal and interest. That’s a potentially huge expense that’s coming out of your pocket.
- NOI is easily manipulated. Expenses can be deferred or accelerated rather easily, which would drastically change a property’s NOI.
- Rent is sometimes hard to project. If you don’t own a property already, you’ll be making an estimate on what you think you can get for rental income. This doesn’t always match up with the market, though, once you purchase a property, fix it up and then go to rent it.
This doesn’t mean you shouldn’t use NOI. It does emphasize, though, the importance of using the calculation as just one of many data points when you’re either looking to purchase a real estate investment property or analyze the performance of your current property.
Make a Solid Real Estate Investment with HomeUnion®
NOI is a great starting point for assessing the viability of a property for real estate investment. Calculating NOI can help you independently compare one property to many others to see which one would be the best fit for you.
While NOI makes it easy to compare properties from all different regions, investing in real estate across the country hasn’t always been so easy. At HomeUnion®, we’ve broken down that barrier, though. We offer the opportunity for individuals to invest in real estate markets across the country, removing the challenge of traditional investing in just the market in which you live.
In addition, HomeUnion® provides a wealth of information and resources so you can learn how to become a successful real estate investor.
To learn more, call us today at (866) 250-5610.