Net Operating Income (NOI): What It Is and How To Calculate It
Inexperienced real estate investors often focus on the potential rents they can collect from a property. But there are also many expenses that come with managing a property, including property taxes, insurance and maintenance.
Net operating income is a metric for measuring the profitability of an income-generating property after subtracting operating expenses. It’s like a crystal ball that shows the true profit potential of an investment property.
But net operating income, or NOI, can be tricky to understand if you’re new to real estate investing. Here’s more about NOI and how to calculate it.
How to calculate net operating income
Calculating NOI is simple: you just need to subtract all operating expenses from the total income generated by the property. However, to do this, you need to know which expenses to include in the formula and which ones to exclude. Let’s look at the NOI formula and then dig deeper into each component.
1. Determine your property revenue
The first step in calculating your NOI is accurately determining the property’s revenue. Revenue includes rents, of course, but also any additional income streams your property might generate. It also takes into account rental vacancies, which represent lost rental income.
This figure is known as gross operating income or effective gross income.
Here’s a step-by-step guide to calculating gross operating income:
- Total rental income. Begin by summing up all the income you expect to receive from renting the property, including monthly rents from all tenants.
- Additional income. Identify and add any other income sources associated with the property. This could be from parking spaces, laundry facilities or any service fees tenants pay over and above their rent.
- Adjust for vacancies. Estimate the potential rental income loss due to vacancies. This is a critical step, as it aligns your revenue expectations with market realities. Calculate the average vacancy rate for your area or use your property’s historical vacancy rate and deduct this amount from your total income calculated in steps one and two.
The gross operating formula looks like this:GOI = (Total Rental Income + Additional Income) – Vacancy Losses
Beyond the primary stream of rental income, properties often have the potential to generate additional revenue through various avenues. Here are some common examples:
- Parking fees
- Laundry facilities
- Vending machines
- Storage units
- Pet fees
- Service fees
- Late fees
2. Calculate your operating expenses
After determining the property’s revenue, the next step in calculating net operating income is to assess your operating expenses. These are costs associated with maintaining and running your property. It’s essential to account for all relevant costs to ensure you have an accurate NOI calculation.
Here are some examples of operating expenses.
- Property taxes. Annual taxes assessed by local governments on your property.
- Repairs and maintenance. Regular upkeep and any necessary repairs to keep the property in good condition and preserve its value.
- Property management fees. If you employ a property manager, this fee is for their property management services, including tenant relationships and maintenance oversight.
- Utilities. Costs for utilities that the property owner is responsible for, such as water, electricity and gas, in common areas or as part of the rental agreement.
- Insurance. Property insurance protects against damages and liability.
- Landscaping. Expenses for maintaining outdoor spaces, including gardening and snow removal.
- Advertising. Costs associated with marketing the property to prospective tenants.
- Legal and professional fees. Expenses for legal advice, accounting services, and other professionals.
3. Subtract operating expenses from your property revenue
After determining your property’s total revenue and calculating the operating expenses, the next step is subtracting operating expenses from your gross operating income to find your NOI. This calculation is crucial as it reveals the property’s true earning potential after accounting for the costs associated with its operation.
What isn’t included in net operating income?
While it’s important to know what is included in net operating income, it’s just as important to understand what it doesn’t include. Excluding certain expenses ensures that NOI remains a focused metric, reflecting only the operational aspect of property performance.
Here are key factors not included in NOI:
The NOI calculation excludes income taxes because the goal is to measure the property’s operational income without the influence of tax strategies or rates, which vary widely among investors.
Depreciation reflects the gradual wear and tear of the property over time. Although it impacts the property’s taxable income, it’s not included in the NOI calculation because it’s not a day-to-day operational cost.
Capital expenditures (CapEx)
Capital expenditures are significant renovations or repairs that extend the life of the property, such as replacing a roof or overhauling the HVAC system. CapEx isn’t included in the NOI calculation because it’s considered an investment in the property’s value, not a regular operating expense.
Debt service refers to the mortgage or loan payments on the property. These payments aren’t reflected in the NOI calculation because the goal is to assess the property’s income-generating ability independently of its financing structure.
Any expenses unrelated to the direct operation of the property, such as the owner’s cell phone bills or travel expenses, are excluded from NOI. This helps maintain NOI’s usefulness as a measure of property performance.
What does net operating income mean for you?
For property owners and investors, net operating income is more than a figure on a financial report — it’s a vital indicator of a property’s financial health and operational efficiency. Understanding and optimizing a property’s NOI can impact your investment strategy.
- Investment value. A higher NOI reflects a property’s profitability and market value. Investors and appraisers often use NOI as a key component in valuing a property. For example, dividing NOI by a property’s cap rate provides an estimate of the market value of commercial real estate. So improving your NOI can increase the property’s value in the eyes of potential buyers.
- Financing opportunities. Lenders look closely at NOI when considering financing or refinancing options for real estate. A strong NOI indicates the property can generate enough income to cover its operating expenses and debt service, making it less risky for the bank or other lenders to make loans.
- Operational efficiency. Analyzing your NOI can help you identify potential operational improvements. Whether you need to reduce unnecessary expenses or increase rents, improving NOI can create a more efficient and profitable investment.