Understanding the financial terms is essential for staying on top of your business’s finances. Thus, today we’ll talk about a financial term that is often used in investments, especially in real estate investments, and this term is Net Operating Income.
The Net Operating Income, or NOI for short, is a calculation that helps you analyze the profitability of an income-generating investment. In the broadest definition, NOI refers to all the revenue from a property, subtracting all the necessary operating expenses.
I’ll talk about this in more detail below; still, I need to note that the NOI calculation does not include expenses related to taxes, amortization, and depreciation of the real estate property and other possible capital expenditures.
Knowing the NOI has a primary role in the management of commercial real estate property. This number is directly related to calculating the expected profits and predicting the potential risks. Read on to learn about Net Operating Income and calculating this critical financial metric.
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What Is Net Operating Income?
Traditionally, the income-producing properties are valued using the net operating income. The NOI is determined by deducting the property’s operating expenses from the gross income it produces.
The NOI also includes any revenue generated by additional amenities. These may include parking, laundry services, and vending machines. The operating expenses regarding running a property are the running and maintenance costs, utilities, insurance premiums, legal fees, property taxes, janitor fees, and repair costs.
Knowing the NOI of a commercial property is also vital when determining the debt coverage ratio. In other words, the NOI describes if a property’s income will cover its operating expenses and debt payments.
Net Operating Income (NOI) Formula
Now that I’ve covered the NOI basics, let’s talk about the net operating income formula. To calculate the net operating income, you need to use the following formula:
- Operating Income (real estate revenue) – any commercial real estate produces income, including rents and various fees like laundry machines, vending machines, parking fees, and more
- Operating Expenses – the operating expenses of commercial real estate include property management fees, property taxes, insurance premiums, and repairs and maintenance
As you can note, the NOI calculation does not include the income taxes, loan payments, leasing commissions, amortization and depreciation of the object, or any capital expenditures like significant repairs or replacement on long-term assets.
Namely, the net operating income is a valuation method that only uses the operating expenses and the property’s operating income. Therefore, the NOI calculation does not include significant spending like a new HVAC system or depreciation – the gradual loss of value of long-term assets.
Net Operating Income Vs. Net Income
There is a significant difference between the net operating income and net income: both are essential metrics when it comes to a real estate property.
The net operating income is the income (revenue) generated by the daily operations of the property when the operating expenses are subtracted. Thus, the total income does not include any possible outside earnings; the operating expenses don’t include any additional expenses outside of the regular operating of the property.
On the other hand, the net income results from subtracting all the expenses from the total income. This is because the total income includes all the income channels – operating income, investment income, interests from offered loans, and anything else. The expenses that are subtracted from the total income include taxes, capital expenditures, and of course, all the operating expenses.
How to Calculate Net Operating Income?
To better understand the net operating income, I’ve prepared a suitable example that will hopefully make things clearer for you. For this, you need to use the net operating (NOI) formula for this calculation:
In our example, an owner rents out a small condo building. In this case, the gross operating income, also known as real estate revenue, includes all the real estate-related channels through which the property generates income:
- Rental income = $25,000
- Parking lot fees = $3,000
- Laundry machines = $500
- Vending machines = $500
Operating income (operating revenue) = $29,000
The operating expenses for running the imaginary small condo building in our example include the following:
- Property management fees = $1,000
- Property taxes = $5,000
- Repair and maintenance = $2,000
- Insurance premium = $1,000
- Janitorial services = $500
Operating Expenses = $9,500
Net Operating Income = $29,000 – $9,500 = $19,500
In the imaginary property in our example, the NOI figure is $19,500, and this is a positive value. However, there are cases where the NOI can have a negative value. It happens where operating expenses are higher than the operating income, which is called net operating loss.
Relation between NOI and Cap Rate
When talking about real estate investments, I need to note another essential financial metric related to the net operating income – the capitalization rate or cap rate. Used alongside the NOI, the cap rate serves to help investors evaluate the value of a property. As a result, this metric allows for a more accurate estimation of the value of an investment property.
To calculate the cap rate of a property, divide the net operating income by the property’s estimated market value. Knowing the cap rate and NOI of a property can help a potential investor determine if a property is worth investing in. In addition, these allow the investors to compare investments and estimate the potential for profitability.
The cap rate is also known as the return of investment or ROI. As I said, the cap rate or ROI helps investors determine if the property is a viable investment opportunity and is directly linked to the NOI of a property.
How to Maximize Net Operating Income
Any property owner looking to increase the profitability of a property should strive to maximize the net operating income. As the NOI is a direct indication of the financial health of a property, the higher the NOI is, the more profitable the property is.
To maximize the net operating income, any property owner should cut expenses, increase rental rates and reduce vacancies. To cut expenses means aiming towards the lowest possible operating costs, like minimizing waste, improving curb appeal, outsourcing labor, reducing utility costs (reduce water and electricity usage), and improving maintenance to optimize costs.
Net Operating Income FAQs
Why Is Net Operating Income so Valuable for Real Estate?
The net operating income provides a good overview of the income a commercial property can generate on its own. Net operating income is calculated by subtracting the operating expenses from the operating income. The NOI excludes the financial factors relevant to all real estate properties like mortgage interests, loans, and taxes, thus giving a clear insight into the profitability of the commercial property.
Is Net Operating Income Calculated Monthly or Annually?
In most cases, the NOI calculation is done on an annual basis. Still, if the owner/investor likes to find the monthly NOI value by dividing the yearly NOI by twelve.
What Is Not Included in Net Operating Income?
The net operating income does not include the income taxes, principal loan payments and loan interest, leasing commissions, tenant leasehold improvements, amortization and depreciation, and capital expenditures.
What Is Noi Called in Other Industries?
When the net operating income is used in other industries, it is referred to as earnings before interest and taxes or EBIT.
What Is the Difference Between EBIT and NOI?
Generally speaking, the NOI is used when evaluating the profitability of a real estate business, and the EBIT is used when speaking about the profitability of a company. Basically, both metrics point to the financial health of a venture.
Net Operating Income shows how much of the operating income is left after subtracting the operating expenses. This metric is primarily used in real estate properties, more precisely in commercial real estate. For example, the NOI shows whether renting out a property is worth the expenses of owning and maintaining it.
The net operating income or NOI is a formula used to determine how profitable property is in a year. It is done by subtracting all operating expenses from the gross operating income. The NOI calculates the operating income vs the operating expenses, and it is done on the property level, but this is directly related to the cap rate of a property.