Net operating income (NOI) is a calculation used to determine profitability.
It’s a metric that is often used in corporate finance to determine profit for all shareholders. In real estate, NOI is used to calculate how profitable a rent-generating property will be for the investor.
If you are considering investing in real estate, you can get ahead by understanding how NOI works, how you can calculate it, and what a good NOI looks like.
Net operating income is equal to all revenue from the property, minus operating expenses.
You don’t include taxes in net operating income, as it’s a pre-tax figure.
The reason for that is that NOI appears on a property’s income and cash flow statement. So, it excludes:
NOI is used to precisely determine the value of any income-producing property. Typically, rental income is the primary income-generating activity, so we will start with rental properties. Then, we will explore other factors that may make it into a net operating income calculation.
NOI = r - oe
In the above case, “r” represents revenue, and “oe” represents operating expenses.
On the surface, this is a very basic formula. But there are almost always many different operating expenses. So, let’s start with other forms of revenue besides rent that a property may produce.
Besides rent, a property can produce revenue for the owner or other stakeholders through a number of means.
Some of the most common and significant examples include:
To calculate a property’s NOI, add up the totals for all sources of revenue.
Do not calculate for maintenance or any form of expenditure. That part comes later.
For now, just find out your “r” value for the formula.
Operating expenses for a property typically include some mix of the following:
While not relevant to NOI, it’s worth noting that many property expenses are tax-deductible.
Now, add up all of the expenses of the property. Subtract the expenses from the revenues, and you have the property’s NOI.
It’s not abnormal for a property’s NOI to be in the negative for some time.
However, you want to aim to get to at least a decent NOI as soon as you reasonably can.
In its original form, it’s hard to provide a benchmark for a “good” NOI. After all, a “good” NOI will vary greatly by location and the market value of the property.
An NOI of $30,000 may be excellent for one property, but awful for another.
Net operating income is a stepping stone to another important figure in real estate: capitalization rate.
A property’s capitalization (cap) rate makes it possible to compare one property’s profitability to other properties’, even when they differ greatly in terms of market value.
Cap rates are an annualized, percentage-based figure for profitability.
The only caveat is that cap rates assume the property was bought without a loan (all cash).
The formula is:
(NOI / Market Value) x 100
In words, you divide the home’s NOI by its market value, then multiply the value by 100.
Now, what is a good cap rate?
A good cap rate and a safe cap rate are two different things. While a high cap rate can be associated with a better investment, it may also be associated with instability.
Overall, a cap rate falling anywhere between 4% and 12% can be considered good in most places.
In competitive housing markets, cap rates can often be lower. When the cap rate goes higher, it is often taken as a sign of risk. The same can be said when it’s lower, but you also run a risk of losing money in the shorter term.
The average cap rate also serves as a metric to show when the property will produce its invested amount. For example, a 10% cap rate property will take about 10 years to recover from the investment. At that point, you’ve made all your money back and can sell the property with its market value in profit.
No, net income does not equal profit.
Simply put, your profit is all the money you make.
Your operating income is all the money you make, MINUS everything you have to pay.
NOI is a specific pre-tax measurement of profitability for your income and cash flow statements. It includes all sources of income and subtracts from them all costs incurred during the same period.
Net operating income is a very specific measurement.
It is relevant primarily to professional real estate investors. So, if you are considering getting into real estate investing, you will want to learn more about all the other metrics used to determine profitability and risk.
Some of them will be useful in helping you make investment decisions. Others are presented during closing and have other purposes.
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