An important financial statistic used by real estate investors to evaluate rental properties is NOI. NOI stands for Net Operating Income. This is a powerful tool that gives an indication of an investment property’s potential profitability.
This article will examine real estate scenarios that use NOI and examine several methods to help with proper NOI computation.
What Does Net Operating Income (NOI) Mean in Real Estate?
By comparing the property’s yearly gains after operating costs with the price of the property or its market value, NOI determines the prospective profitability of a rental property.
Real estate NOI helps to forecast a property’s potential profitability using all of the income it produces. Because of this, the investor’s income taxes, debt service, mortgage interest payments, or capital expenses are NOT deducted from net operating income.
In contrast to other financial indicators for real estate investments like Cash-on-Cash Return, NOI is less susceptible to manipulation because it does not include variable elements like debt service.
An investor can get a better grasp of the likely annual cash flow for an investment relative to the operating costs of the investment by looking at a property’s current and forecasted NOI.
Related: Real Estate Investment Basics: What Is IRR?
What is the NOI Formula?
The following is the fundamental formula for computing NOI:
NOI = Gross operating income – Operating costs
Therefore, the NOI is $15,750 for an investment property with an annual gross operating revenue of $20,000 and a yearly operating expense of $4,250.
However, a lot of real estate investors rework the specific NOI calculation so that it takes into account things like rental income that may be lost due to vacancies and additional income sources (such as late fees, pet rent, and appliance rent).
A modified NOI formula, presented below, includes other sources of income and expenditure:
- NOI = Potential rental income + Other income – Vacancy losses – Operating costs
How to Calculate NOI
The components listed below are utilized to compute NOI with greater accuracy:
Potential Rental Income
Potential rental income is the total revenue a property could bring in if it were leased at a fair market value compared to other properties and was occupied 100% of the time.
Vacancy Loss
This is the amount of lost rental income from vacancy brought on by the inability to lease parts of the property, turnover of tenants, or eviction of a tenant for missed rent payments.
Gross Rental Income
By deducting vacancy loss from the anticipated rental income, the income a landlord may expect to earn from rent is determined.
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Additional Income
Income not included in the base or regular monthly rent, including late fees, equipment rent, or additional services rendered at the property (such as parking, concierge, laundry, vending machines, etc.), is known as additional income.
Gross Operating Income
This is the sum of Gross Rental Income and Additional Income.
Operational Costs
These are the direct expenses for running the property and earning a fair market price for rent while keeping its value high.
Net Operating Income
The NOI is computed by deducting the Operational Costs from the Gross Operating Income.
Note that ongoing fees or expenses that may differ between investors are not accounted for in NOI.
The measurement of NOI excludes certain charges, including an individual investor’s income tax, debt payment, capital expenses, mortgage interest, and depreciation. NOI does not include these sorts of variable expenses. The NOI is supposed to be an objective measure relating to the property, not the individual investor who holds it.
Related: Real Estate Investment Basics: Loan to Value
Operating vs. Other Expenses
A few of the key items included in Operating Costs are expenses that relate to tenant screening, marketing charges, property management, leasing fees, property insurance, property taxes, repair and maintenance, and other utilities the landlord is responsible for paying.
Seasonal costs like snow removal, HVAC system maintenance, and gardening are also included in standard Operating Costs.
NOI is typically determined annually rather than on a month-by-month basis because operating costs (and occasionally Gross Operating Income) have the potential to change each month.
Other Expenses
Other costs that are excluded from the calculation of NOI include debt service, capital improvements, and mortgage interest payments made to increase a property’s value.
How Do You Use NOI?
Lenders and real estate investors compute the debt payment coverage ratio, property value, and capitalization rate using NOI:
Rate of Capitalization
The capitalization rate, commonly referred to as the cap rate, is a term that assesses the potential rate of ROI, or return on investment, both now and in the future.
The possible ROI increases with the cap rate.
NOI is divided by the value of the property to determine the cap rate:
NOI / Property Value = Cap Rate
Property Worth
Property value can also be determined using the same Cap Rate method, which takes the NOI and the Cap Rate into account:
Property Value = NOI / Cap Rate
Possible NOI
By utilizing the Cap Rate for comparable rental properties found within the same market, you can also use the Cap Rate formula to determine a property’s potential NOI.
Potential NOI = Property Value x Cap Rate
Debt Service Coverage Ratio
Lenders and real estate investors use the Debt Service Coverage Ratio (DSCR) formula to assess whether there is enough income to cover the mortgage.
The safety buffer increases with the DSCR ratio when expenses are greater than anticipated or revenue is less than anticipated:
NOI / Annual Debt Service = DSCR
Related: What Is “Liquidity” In Real Estate And When Is It Needed?
Benefits of Using NOI
The use of NOI provides a more precise picture of what can be anticipated regarding potential future income coming from a property.
Lenders and real estate investors use NOI to compare the annual NOI against the annual debt service to assess the risk of an investment.
Downsides of Using NOI
Depending on the depth of tenant screening and quality of property management, NOI can differ greatly from actual performance.
Some financial calculations, like DSCR and Cap Rate, will also be impacted if NOI is incorrectly computed due to faulty rent projections, vacancy loss, or operating expenses.
Accurately Analyze Your NOI
It is important to understand and analyze your property’s NOI fully. This will give you an idea of what the property’s potential profitability could end up being. Just make sure to keep all factors in mind; otherwise, the number will be inaccurate. However, with these considerations in mind, NOI is a powerful tool you’ll want to take advantage of.
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