Whether you’re a newbie or seasoned investor, one of the first things you consider when looking at properties to invest in is their profitability. Now, one of the most commonly used metrics that investors use to gauge the potential of an income property is the net operating income (NOI), a metric designed to measure your overall profitability and performance, excluding a few factors. But beyond that, what is NOI in real estate exactly? We’ll answer this question and more so, continue reading!
Key Takeaways
- The net operating income is a performance metric that shows profitability based on income and operating expenses, but excluding income taxes, depreciation, and financing.
- Investors need a comprehensive record of a property’s effective gross income and operating expenses to calculate for the net operating income.
- The net operating income plays a key role in calculating and improving a property’s capitalization rate. In addition, it’s a critical component in determining property value; even small increases in NOI can lead to significant boosts in equity.
What Is NOI in Real in Real Estate?
Net Operating Income (NOI) is the total income a property generates minus all necessary operating expenses. It represents the property’s actual profitability before taxes and financing costs.
As the best property management company in Austin, we understand that the NOI, or net operating income, is a key performance indicator that landlords, property managers, and investors use to measure true profits. How? By taking operational costs into account.
Let’s say a rental income property records an annual income of $250,000 from tenant rent payments, fees, and more. Does this mean that the whole $250,000 is the property owner’s profit? The answer is no. This is because you still have to pay for insurance, repair and maintenance, utilities, vendor fees, taxes (if applicable), and the like. These are expenses necessary to keep the rental property up and running, so these are costs that are taken from the initial revenue.
How to Calculate NOI (With Formula)
To calculate Net Operating Income (NOI), subtract all vacancy losses and operating expenses from the total potential income generated by a property.
To explain in more depth, understanding the concept of what is NOI in real estate is only the first piece of the puzzle. Knowing how to calculate a property’s net operating income will provide you with a clear picture of the real income generated by the property, minus the operational costs. But, how do you do it?
In order to calculate the NOI, you first need to have a complete and detailed record of the property’s Effective Gross Income and operational expenses. First, let’s talk about Effective Gross Income. Generally, this includes Potential Rental Income (the total rent if the building were 100% full) plus other sources of revenue minus a Vacancy Allowance (income lost when units are empty). Other sources include parking fees, late fees, amenity fees, vending machine revenue, laundry services, storage fees, pet rent, and similar sources.
Then there are the operating costs, which are the ongoing expenses that landlords pay monthly to run and maintain their property, accumulated for the year. However, this does not include mortgage payments, loan interests, property depreciation, income taxes, or Capital Expenditures (major long-term upgrades like a new roof).
Once you have this on hand, you can easily determine what the net operating income for the rental is using this formula:
Net Operating Income (NOI) = Effective Gross Operating Income – Operating Expenses
Let’s take our initial example of a rental income property generating $250,000 of gross rental income. Assuming you have a 5% vacancy loss ($12,500), let’s say that the operating costs for this property amount to $60,000. Using the formula, the NOI for this property will be:
NOI = ($250,000 – $12,500) – $60,000 = $177,500
NOI vs Net Income vs Cash Flow
While NOI focuses purely on a property’s operational efficiency by excluding debt and taxes, Net Income and Cash Flow can give you a broader financial picture. They include mortgage payments, income taxes, and major capital improvements.
Aside from knowing what is NOI in real estate, you also need to understand how it differs from other closely related property performance indicators, such as net income and cash flow. While these metrics all focus on the profit potential of a rental property, it’s important for you as an investor to understand what exactly these metrics are trying to tell you.
First, the net operating income is a metric that looks at not just profitability, but specifically at cost efficiency. It does not, however, take into account the financing aspect of a real estate investment. Basically, the net operating income does not care about who or how an investment is acquired. By excluding mortgage payments, loan debts, and even income taxes in the equation, you can use the NOI to gauge and guide operational decisions that can help boost rent income and minimize operational costs. This also allows you to compare two properties fairly even if one is bought with cash and the other with a loan.
But what about net income and cash flow? In the simplest terms, net income accounts for aspects that the NOI excludes. Net income includes debt service (principal and interest), taxes, amortization, and income taxes, among others, which provides investors with a deeper understanding of the actual profit of the income property. Then there’s cash flow, which looks at whether the property is generating income after all expenses, including operating expenses, debt service, and capital expenditures. It shows the money you have on hand, which is critical to determine not just profitability, but also stability.
How Investors Use NOI to Value Property (Cap Rate)
One of the most effective ways to use NOI to value a property is to determine a property’s capitalization rate (cap rate).
Here, the cap rate helps investors see the expected percentage rate of return in correlation to market conditions and perceived risks. It uses the NOI, which represents income after expenses, and the property’s purchase price or market value.
Crucially, the relationship between NOI and Cap Rate allows you to determine a property’s value. If the market cap rate is 5%, a property with an NOI of $100,000 is worth $2,000,000.
But how do investors use the cap rate strategically? First, cap rates help compare different investment opportunities, regardless of the type of property, and even locations. And given that cap rates are influenced by changes in the NOI, investors can also use it to test different strategies, such as whether they want to raise rent to increase income, add capital improvements, or cut down on expenses.
How to Increase Your NOI and Property Value
Because property value is tied to your NOI, savvy investors look for ways to “force” appreciation by:
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Increasing Revenue: Adding “Valet Trash” services, implementing pet rent, or installing solar panels to sell energy back to the grid.
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Decreasing Expenses: Appealing property tax assessments, installing low-flow water fixtures to reduce utility bills, or renegotiating vendor contracts.
A Disclaimer
We’re only providing general information in this article for educational purposes only. While we aim for accuracy and reliability, the information shared is not meant to be relied on as legal, tax, financial, or specific regulatory advice. We strongly recommend that you always consult with a licensed attorney, CPA, or other qualified professional in your specific jurisdiction for advice tailored to your unique circumstances, as reading this blog does not establish a client or advisory relationship with BMG.
How Bay Property Management Can Help
To understand what is NOI in real estate, you need to start at the very beginning – from knowing the concept, learning the formula, and identifying the differences between similar metrics. With the net operating income, you can get a clearer picture of income, expenditures, and investment growth potential.
Need help managing your investment in Austin and nearby areas? We at Bay Property Management Group are ready to help. We can help you maximize your profits by finding and screening for qualified tenants, handling inspections, drafting airtight leases, and coordinating preventative maintenance. Interested? Contact us today to learn more about our services.
