The net operating income, or NOI, is an essential calculation used by investors to determine how valuable a property is. In other words, it demonstrates whether or not the property will have an income stream.
Why is NOI important?
As obvious as it may seem, novice investors tend to get caught in the idea of owning a property that has a profit potential. However, a smart investor would do well to realize that the best properties are those that are already producing an income stream.
Those that require no amount of work to ensure a steady income stream, such as triple net properties, are considered low risk. Properties that require a significant amount of renovation, or have one or more vacancies, are high risk.
How Is NOI Calculated?
Net operating income is calculated by adding up all the expenses associated with the property. Investors can either use past financial statements, or estimate future expenses based on a pro forma.
Expenses include all costs for:
- acquisition and sale
- expected vacancy
- repairs and maintenance
- credit loss (the expected amount lost due to non-payment of rent)
- mortgage interest
- marketing and advertising
- legal and accounting
- some utilities
- vacancy and credit loss
Once the total expenses are added, you can simply deduct it from the gross operating income of the property.
Gross Operating Income – Gross Operating Expenses
To determine the gross operating income, you’ll first need to know the property’s gross potential income. GPI is the amount you would make from the property if there were no vacancies and all rent was fully paid. You can then take this number, and multiply it by the percentage of current vacancies for your market, property, and location.
If the property accrues income from other sources, such as parking, billboard/signage, laundry and vending machines, then that should be factored in as well.
If you subtract the Operating Expenses from the Gross Operating Income and you will get the NOI.
Are All Expenses Operating Expenses?
Many investors assume that any expense incurred by the property is an operating expense. However, this is far from true. Operating expenses are expenses that are solely necessary for the operation of the property.
Thus, any money spent on repairing and maintaining a property would be an operating expense – but money spent on renovating a property is not.The same goes for loan payments, depreciation, and capital expenditures, which are necessary in order to own the property and ensure it continues to produce income, but not to operate it.
Landscaping, supplies, and snow removal are operating expenses, as are property taxes. However, any personal tax income liabilities from the property are not operating expenses.
For example, utilities, supplies, snow removal and property management are all operating expenses. Repairs and maintenance are operating expenses, but improvements and additions are not – they are capital expenditures. Property tax is an operating expense, but your personal income-tax liability generated by the property is not.
Your mortgage interest may be a deductible expense, but it is not an operating expense. You need a mortgage to buy the property, but not to operate it.
What About Reserves For Replacement?
Funds set aside for major repairs are called reserves. HVAC system or roof repairs are two common examples of repairs that require a significant sum of money to be set aside to ensure funds are available to cover these expenses.
Whether or not they should be included among operating expenses varies. Some don’t include reserves, since technically they aren’t necessary for operating the property as the actual need for the repair has not occurred.
Others do include reserves when calculating operating expenses, since technically they are reserved for a repair (which is an operating expense), and because the ability of a property to service debt is an important part of estimating property value. Reserves also ensure a property maintains its value in a competitive marketplace.
How does NOI relate to the CAP rate?
While the NOI reveals the return on the purchase price of the property, the cap rate represents the rate of return. Capitalization rate is calculated by taking the NOI and dividing it by the purchase price. Thus CAP rate, similar to the profitability index, is a percentage that can be used to decide whether or not a particular property has profit potential.
To Sum Up
Net operating income is found to be resistant to manipulation since it can grow by increasing the amount of rents and other related fees or by reducing some of the operating expenses. It is different from taxable income or cash flow.
Net operating income helps owners to determine different ratios, such as CAP rate which further on determines property’s value. NOI is also employed in debt coverage ratio (DCR) which further on lets investors know whether the income covers the expenses and payments.
If the property is likely to succeed, the lender then determines the loan amount to the investor. Yet, the lender’s mortgage request may be dismissed in cases when the property undergoes NOI loss.