Net Operating Income
In this article, we want to discuss the role of net
operating income to real estate analysis. How it’s
calculated and then how real estate analysts use net
operating income to determine the profitability of
investment real estate.
Net operating income (or NOI) is one of the most important
calculations made during the analysis of any real estate
investment because it represents the property’s potential income after all vacancy andoperating expenses have been subtracted. In other words, net operating income virtually represents the income property’s productivity, or measure of cash flow.
To help plant the idea, let’s consider net operating income in one of the following two ways, depending on whether or not a mortgage exists.
1. The investor pays all cash for the property. In this
case, since the property is wholly owned and has no debt,
NOI is the return expected from a property for any given
annual period before taxes and depreciation are considered.
Given no deduction for debt service (loan payment), you can
regard net operating income in this case as the annual cash
flow before taxes (or CFBT).
2. The investor finances the property. Here, since the
property has a mortgage, NOI should be regarded as the
anticipated amount of cash flow available to pay the
mortgage. In this case, only the remainder of NOI (after
you subtract the annual loan payment) becomes the annual
cash flow (or CFBT).
Okay, let’s summarize. If you pay all-cash for a rental
property, because there are no mortgage payments, NOI by
default represents the property’s cash flow. On the other
hand, when there are mortgage payments, NOI represents the
amount of money available to service the debt, and then,
subsequently the cash flow only after the loan payments.
How to Calculate Net Operating Income
Gross Operating Income less Operating Expenses = Net
Operating Income
For example, let’s assume you’re doing a real estate
analysis on an apartment building that produces a gross
operating income of $100,000 and operating expenses of
$42,000. What is the NOI?
This should be easy. $100,000 less $42,000 equals $58,000.
Okay, but let’s make sure that you understand both
components in the formula.
1) Gross Operating Income (GOI) - This equals the rental
property’s annual gross scheduled income less vacancy and
credit loss. In other words, GOI is the actual income you
expect the rental property to produce.
2) Operating Expense - An operating expense ensures the
property’s continued ability to produce income. Whereas
such things as property taxes, utilities, and maintenance
and repairs are operating expenses, mortgage payments,
depreciation, and capital expenditures are not considered
operating expenses.
The Role of Net Operating Income
Net operating income plays a large role in a variety of
real estate investment and holding period decisions.
Capitalization rate, for instance, is calculated by
dividing NOI by sale price, and property value is
calculated by dividing NOI by capitalization rate.
Net operating income also plays a large role with lenders.
Debt coverage ratio (or DCR), for instance, is calculated
by dividing the net operating income by annual loan payment.
The Credibility of Net Operating Income
Not unlike any component in a real estate analysis, net
operating income is only as good as the numbers used to
compute it are credible.
Whether you use real estate investment software, a
spreadsheet, or pencil and paper for your real estate
analysis, you must spend the time to validate the numbers
and reconstruct the owner’s representations for income and
operating expenses if necessary.
Prudent real estate analysis demands it so rely on nothing
less then the most credible net operating income possible.
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James Kobzeff is the developer of ProAPOD Real Estate
Investment Software. Do a real estate analysis. Create cash
flow, rate of return, and profitability analysis
presentations for rental properties in minutes!
For more information, visit ProAPOD.com
