Few acronyms are as crucial to real estate investors as NOI. NOI, or net operating income, reflects the potential profitability of a property or investment. Therefore, all investors need to be familiar with the NOI calculation to compare properties and analyze their finances. Here’s everything you need to know about NOI in real estate.
Life Bridge Capital is a leading real estate syndication company. We offer our investment partners the opportunity to leverage shares of multifamily rental properties into a passive monthly income. Learn More
What is Net Operating Income?
Net operating income (NOI) gives potential investors quick and clear insight regarding a property’s overall profit potential. A property’s NOI represents its income after expenses are subtracted. The NOI is then used to determine a property’s capitalization rate, and thus its market value.
The NOI encompasses all sources of income for a building, not just rental income. Examples of additional sources of income include parking permits, laundry and vending machines, valet trash services, utility offsets, pet fees, and shared-space rental fees.
How to Calculate NOI
To calculate the net operating income of a property, first add all sources of revenue. Then, sum all operating expenses. Finally, from the total revenue, subtract the total expenses:
NOI = Real Estate Revenue – Expenses
NOI Expense Exclusions
While calculating income sources is pretty straightforward, tabulating the expenses can be more challenging, because many common expenses are excluded from the formula. For example, income taxes, debt principal and interest, capital expenditures, property depreciation, repair for wear and tear, and deferred maintenance do not belong in the final tally.
Similarly, it can be easy to overlook some of the expenses that should find their way into the calculation. Property taxes, insurance, utilities not paid by tenants, attorney costs, property management fees, and maintenance fees contribute to the total operating expense.
How to Use NOI
Determining the NOI of real estate, whether already owned or a prospective purchase, is crucial because the NOI is closely tied to the building value.
First and foremost, it is one of the components of the capitalization rate formula. NOI divided by the purchase price equals the cap rate. So, by increasing the NOI, owners can improve an investment property’s cap rate. You can also use a property’s NOI and the cap rate of comparable properties to determine the market value.
When obtaining a commercial real estate loan for a property, lenders will use the NOI to determine the maximum amount they will lend using the debt-service coverage rate (DSCR). Calculate the DSCR by dividing the annual NOI by the annual debt service amount. The debt service amount is the total the borrower pays each year toward the loan, including principle and interest. Therefore, the larger the NOI, the larger the loan a borrower can take out.
Shortcomings of the NOI Calculation
There remain crucial bits of information missing from the picture for all the benefits of knowing a property’s NOI. Awareness of these exclusions allows investors to better use NOI information in context.
We previously addressed typical expenses not included in the calculation, because they are not considered everyday operating expenses. Savvy investors will know that those types of expenses ultimately impact profits. However, the NOI can be deceiving when an owner skews the figures to bolster a property’s financial wellbeing inaccurately, and the deception often happens by deferring maintenance.
Maintenance and repairs should be included in the NOI calculation. These include everything from groundskeeping to electrical work and plumbing and even essential structural maintenance, like patching Stucco.
Deferring maintenance produces a skewed report of the property’s expenses. In addition, if the previous owner had a long practice of deferring maintenance, future owners are likely to encounter the need for corrective maintenance, which is more expensive than performing maintenance promptly. As a result, misleading deferred maintenance further reduces the benefit of the NOI calculation.
How to Improve NOI
Investors should improve a property’s NOI to increase passive income and prepare a property for sale. Here are a few tips to start:
- Create Additional Income Streams: Find additional services or features on the property to monetize. For example, vending machines add little work because they are maintained by the vending company but add additional revenue. Conversely, bigger-ticket items like permitted parking and on-site gym classes require more oversight but will increase income.
- Minimize Operating Expenses: Trimming the fat has long been a budgeting mechanism, and it also boosts the NOI. Efficient property management companies earn their fees through sourcing low-cost subcontractors for maintenance and other services to run a tight ship. Other low-hanging fruits to reduce costs include the institution of tenant offset of utilities and the elimination of little-used amenities that do not bring value.
- Increase Rental Income: Increasing rental income can bring significant changes to the NOI. While raising the rent may be the obvious choice, reducing vacancies and making unit turnaround more efficient also increase rental income.
Conclusion
Because it is central to property valuation and profitability, familiarity with real estate NOI calculation and use is the bread and butter for real estate investment property analysis.
Life Bridge Capital is a leading real estate syndication company. We offer our investment partners the opportunity to leverage shares of multifamily rental properties into a passive monthly income. Learn More
