Seasoned real estate investors bury themselves in statistics when they’re looking for new opportunities, because data and calculation are crucial when a person is weighing the benefits of income-generating properties like apartment buildings and rental homes.
One of the most common and telling formulas investors rely on is the property’s net operating income (NOI), which helps determine the profitability of a property.
In this article, we’ll explain how you can use net operating income to help decide if a real estate property is right for you.
What is Net Operating Income?
NOI is a statistic that evaluates a revenue-generating real estate property’s profitability.
The net operating income formula is quite simple:
Property revenue - operating expenses
Most analysts calculate NOI annually, but it’s perfectly fine to measure it monthly or quarterly, especially when it comes to larger properties.
How Real Estate Investors Can Calculate NOI
There are three basic steps for finding NOI real estate investors should take:
Step 1: Add Up Gross Income
Add up the total amount the property generates in rental fees and, if applicable, subtract the estimated amount lost from any vacant units.
Include revenue from sources besides tenant rentals — for example:
- coin-operated washers and dryers
- soda machines
- parking space leases
- or any other services
Step 2: Add Up Operating Expenses
Next, calculate how much it costs to run the property on an everyday basis. Account for all expenses that are necessary for insuring, maintaining, protecting, and managing all physical aspects of the property.
Step 3: Subtract Operating Expenses from Gross Income
The difference between the two figures, simply put, is the rental property’s NOI.
Next, we’ll look at both the advantages and disadvantages of NOI.
Advantages of NOI
An accurate NOI gives a potential investor a good idea of how much revenue they can expect to gain from a given property.
Since NOI only employs hard data based on documented income and expenses, it’s not subjective or easily bent to suit individual interests.
NOI also helps investors arrive at a fair initial value for the property by allowing them to compare it with other nearby properties.
Lenders also use NOI to assess the risk associated with the property (and therefore the risk of the loan they may issue).
Disadvantages of NOI
Keep in mind that NOI also comes with its fair share of disadvantages.
For example, NOI doesn’t account for management quality, a major factor in how a property generates income.
Some property managers are better equipped to minimize repairs and deal effectively with tenant issues and can therefore keep operating costs down.
Others may not have those skills or abilities, and their operating costs may skyrocket.
Also, NOI must derive from correct data. If the rental income is wrong, the NOI will be off.
Not all investors have the same methods or knowledge levels for calculating NOI, so it may be inconsistent among multiple parties, another disadvantage.
What Expenses Are Included in NOI?
Some of the costs to consider when calculating operating costs for NOI include:
- Property management fees
- Utilities (not paid by tenants)
- Repairs (not made by tenants)
- Property taxes
- Legal fees (i.e., litigation, drafting lease agreements)
For purposes of figuring out NOI, these common expenditures should not be considered to be operating costs:
- Income taxes
- Interest (i.e., mortgage payments or business loans)
- Debt service
- Improvements made by tenants
- Repairs related to wear-and-tear
Capital expenditures, like remodels, major appliances, repaving driveways would also not be considered in a calculating of NOI.
What is a Good NOI in Real Estate?
There’s no established “good” number for NOI.
Rental rates and operating expenses vary widely from area to area — an apartment building in downtown Manhattan has far different aspects than one in Little Rock, Arkansas.
What matters is how your property's NOI compares to others in the vicinity.
That comparison can offer insight into whether you're spending too much or too little on operating costs or charging enough rent.
If a neighboring property similar to yours has a greater NOI, you might want to consider raising rents or finding ways to rein in expenses.
An Example of How to Calculate NOI
Let’s look at an example of how to calculate NOI.
There’s a 150-unit apartment building in the downtown area of a mid-sized town priced at $12,000,000.
One-third of the units cost $1,250 in monthly rent, another third of the units cost $1,500, and the remaining third cost $1,750.
Let’s say there are two units, both of which are $1,500 to rent, that are typically vacant.
The gross annual income breaks down like this:
- 50 x ($1250 x 12) = $750,000
- 50 x ($1500 x 12) = $900,000
- 50 x ($1750 x 12) = $1,050,000
- 2 x (-$1500 x 12) = minus $36,000 (the vacant units)
- Total gross rental income: $2,664,000
On top of that, let’s say the building has coin-operated washers and dryers that bring in $36,000 a year.
So, add that to the gross rental income to get a conveniently round figure for this example:
$2,664,000 + $36,000 = $2,700,000 annual gross income
Now, let’s add up the annual operating costs of this building. The amounts shown are for example purposes only — they may be quite different in your area.
- Property management fees: $1,200,000
- Insurance: $22,500
- Utilities (not paid by tenants): $15,000
- Building repairs: $30,000
- Annual property taxes: $108,000
- Total annual operating costs: $1,375,500
Finally, to compute the NOI, subtract the operating expenses from the rental income:
$2,700,000 - $1,375,500 = $1,324,500 NOI
How NOI is Used to Determine Cap Rate
Net operating income also helps investors arrive at a rental property’s capitalization rate, also known as cap rate.
Cap rate makes it possible to compare the property with other, dissimilar properties in the local area. It can also help an investor decide whether a property needs to be “fixed and flipped” or can be rented as is.
This is the annual rate of return an investor can expect on a building, using the presupposition that it was bought entirely with cash.
A cap rate between 8% and 12% is considered good for a rental property in most areas (ones in expensive cities may go lower).
The formula for cap rate is:
(NOI ÷ Market Value) x 100
Using the last example, the cap rate for the building would be arrived at like this:
($1,324,500 ÷ $12,000,000) x 100 = 11.0375%
NOI: The Bottom Line
Net operating income shouldn’t be the only number you consider with a new real estate investment — things such as ARV, cash on cash return, price to rent ratio can also be factored in — but it’s certainly important.
As long as your source data is complete and exact, NOI is an immensely beneficial tool and can help you on your real estate investing journey.