What is Net Operating Income (NOI)
If you’re new to real estate investing, one of the most important numbers you’ll come across is net operating income.
But what exactly is it? And how does it affect your investment decisions?
You might have heard this term thrown around at a cocktail party or in a passing conversation with a friend. But what does it mean? What does it tell you about a property’s potential as an investment?
If you’re like many investors out there, you may not be sure what to make of net operating income (or NOI). That’s okay. We’ll help demystify the concept and show how understanding it can help guide your next and current investments!
What Is Net Operating Income?
It tells you how much money you’ll earn on your investment, and how quickly your property will pay for itself.
Net Operating Income (NOI) is a crucial metric that investors use to evaluate properties. It’s a fundamental way of measuring the profitability of an investment property and is used to determine the potential return on investment.
According to Investopedia, NOI is the net income of a property after all expenses are taken into consideration. The most important expenses that need consideration include:
- Carrying costs
- Interest on financing
The rest are other minor expenses, such as:
- Property management
Some special expenses may need to be added, depending on your situation. These include:
- Capital expenditures
- Leasing commissions
It’s imperative to understand this figure because it tells you how much money you’ll earn on your investment, and how quickly your property will pay for itself. Every potential investment has two sides: what it can do for you and what you have to give up getting it. The NOI helps you compare these two factors.
How to Calculate NOI
It is easy enough to calculate your NOI if you know all of your expenses upfront (including future ones). However, it is more realistic when calculated at the end of the year because there will be some expenses for which you will not have planned or known about until after the fact.
If you want to do a quick estimate at any point during the year, just add up all your anticipated costs and subtract all anticipated income from rent and other sources from that figure. NOI can be calculated on a property-by-property basis or an aggregate basis for a portfolio of properties.
The formula for net operating income is as follows:
Net Operating Income = Gross Income – Total Expenses
You can make this simple by visiting our Online Calculator, available in our premium package.
If you rented out an apartment building and collected $50,000 over twelve months but spent:
- $10,000 on repairs and maintenance for the building.
- $1,000 on the insurance policy for the building.
- $1,000 in taxes.
- $10,000 on the mortgage.
- $3,000 in vacancy expenses (the difference between what you collect in rent and what you’d get if the unit were vacant).
NOI = Gross income ($50,000) – Total Expenses ($10,000 + 1,000 + $1,000 + $10,00 + $3,000)
The gross income is $50,000.
Total Expenses are $25,000.
Therefore, your annual net operation income is $25,000 = ($50,000 – $25,000).
Good vs Bad NOI
Either way, bad NOI means trouble for your investment.
As an investor, there are times when you might be curious about the difference between good and bad net operating income. While the definition of these terms is straightforward, they can seem quite subjective at first glance. But it’s important to understand these terms because they can majorly impact the value of a potential investment property.
Good and bad are relative terms that depend on several factors, including what kind of real estate you’re looking at and how long you plan to hold the property. Good NOI would generally be considered a rental income that is higher than expenses, which means that the value of the property will increase over time.
Bad NOI means that there isn’t enough money to pay the bills. Bad NOI can be a problem for several reasons:
- It might mean that serious problems with the building are eating into its profits.
- It might require repairs or upgrades that involve money you don’t have yet.
- It could also mean that your expenses are too high for the market.
- Perhaps, you’re charging lower rent than other comparable properties or hiring more expensive contractors to maintain the property.
Either way, bad NOI means trouble for your investment.
Net Operating Income Versus Cash Flow (NOI vs. CF)
Investing in real estate is fun and exciting, but knowing the difference between NOI and cash flow can make or break a deal. Don‘t get caught up in the numbers. Here’s the scoop.
Net operating income is the owner’s net profit after paying all operating expenses, including property taxes and insurance, etc. Calculating net operating income is relatively simple: take your gross monthly rental income and subtract all expenses. The resulting number is your gross NOI.
Cash flow is KING for investors, so measure it when looking at investment opportunities. In traditional accounting, you record your cash flow as positive or negative following your overall budget and business plan to create a snapshot of your investment’s cash position over time.
It’s also useful when evaluating investments as it helps you understand how much money will be coming in and out of an investment and if there are enough positive numbers to keep your business afloat.
An apartment building has a net operating income of $10,000, and its cash flow is $12,000.
Which one is more important?
The answer is that both are important, but for different reasons. The cash flow is more important because it shows that you have sufficient income to pay all your expenses with complete liquidity left over. This means that if a tenant decides not to pay rent for some reason, you still have enough income to survive without having to dip into your own pocket.
The net operating income shows that even after paying all your expenses and costs of ownership, some profit is still left over. A good rule of thumb when evaluating properties is to ensure that you have a minimum cash flow equal to two months of operating costs. Furthermore, an additional 10% on top of that minimum in cash flow to account for emergencies is helpful.
Most people think their property’s value is based on its appraised value, but the true value can be found in its net operating income.
Strategies to Increase Net Operating Income
When it comes to real estate, and more specifically NOI, propertyonion.com has many ways to improve the bottom line and increase the value of a property. Below is a list of successful strategies for increasing NOI.
Strategy 1: Reduce expenses:
- Replace old, inefficient appliances.
- Make smart decisions regarding property management and tenant selection.
- Add energy-efficient lighting fixtures.
- Ensure proper insulation of the building and all plumbing.
- Replace single-pane windows with double-paned ones or install storm windows or shades.
Strategy 2: Increase rents/leases:
- Charge more for luxury units (e.g., penthouse).
- Charge additional fees for on-site amenities (e.g., fitness center).
- Use a leasing agent to negotiate better deals for tenants and collect more upfront rent.
Strategy 3: Increase the value of the property:
- Update the landscaping and paint the exterior of the building.
- Do a better job marketing the property.
- Remodel individual units to increase their value and marketability.
Strategy 4: Improve the neighborhood:
- Survey residents to determine what they like about living there and what they don’t like about your property.
- Address issues people have with the local county government, such as roads, security, and social amenities.
- Look for opportunities to build new units and increase the value of your property.
The Importance of Net Operating Income
Most people think their property’s value is based on its appraised value, but the true value can be found in its net operating income. Here are some reasons why it’s essential to calculate this figure accurately:
- Gives you a more accurate idea of your profits.
- Helps you decide what to do with your property, whether it be renting or selling.
- Shows whether a property is worth improving or not since the improvements will affect your bottom line.
- Allows you to compare properties easily and helps you find the best deal for your money.
- Can give you an idea of how much to offer on a property and what to ask in rent.
- Helps you prepare for the future. If you’re trying to save up for a property and have a certain amount in mind that would be enough, this calculation can help you figure out how long it would take to recoup your initial investment.
Turn Your Assets into Income Today!
Ultimately, you need to do your research and be as knowledgeable as you can. Understand how a property’s expenses affect its value and consider this when doing valuation estimates. Know those numbers inside out and understand how they affect the overall net operating income of a property. Finally, never be afraid to ask. If there is something you don’t understand or if you have any questions, get in touch with us.