- What is Net Operating Income (NOI)?
- How Real Estate Investors Can Calculate NOI Real Estate
- Advantages of NOI Real Estate
- Disadvantages of NOI Real Estate
- What Expenses Are Included in NOI Real Estate?
- Is Mortgage Included In NOI Real Estate?
- What is a Good NOI in Real Estate?
- An Example of How to Calculate NOI Real Estate
- How NOI Real Estate is Used to Determine Cap Rate
- NOI Real Estate Vs Ebitda: What's the Difference?
- When To Use NOI Real Estate (and When Not To)
- How To Improve NOI Real Estate: 4 Options
- NOI Real Estate: The Bottom Line
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:
- what NOI real estate is
- how to calculate NOI real estate
- how NOI real estate differs from other real estate investing formulas
- how to improve your NOI real estate
- and more
If you're ready to learn everything you need to know about NOI real estate, let's get started!
What is Net Operating Income (NOI)?
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 Real Estate
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 Real Estate
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 Real Estate
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 Real Estate?
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, and repaving driveways would also not be considered in a calculation of NOI real estate.
Is Mortgage Included In NOI Real Estate?
NOI calculations do not include mortgage payments.
There's a basic reason for this. Mortgage payments aren't deemed to be an operating expense. They represent an expense for financing a property but not actually operating it. It's only the ongoing costs necessary to run the property taken into consideration.
Routine expenses for owning it are something altogether.
What is a Good NOI in Real Estate?
NOI real estate is subjective to the local market. 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.
So, in order to determine a good NOI real estate, you need to do the following two things:
- Determine the average NOI for comparable properties in your local market
- Do better than the average
If your NOI real estate isn't optimal, there are several things you can do to improve it.
- Increasing your curb appeal is always a good start.
- Cater to the five senses of people in terms of hearing, touch, taste, smell, and sight.
- Make sure the landscaping is perfect and the structure itself is well-maintained.
Indoor upgrades matter too, from ceiling fans and vinyl plank flooring to new fixtures and hardware.
One big step you can take is increasing lease terms and rates. If you have an occupancy rate over 95% and a loss-to-lease rate less than 3%, then you should be able to extend lease terms past one year in length or just raise rates safely.
An Example of How to Calculate NOI Real Estate
Let’s look at an example of how to calculate NOI real estate.
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 Real Estate is Used to Determine Cap Rate
NOI real estate 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 Real Estate Vs Ebitda: What's the Difference?
On the other hand, EBITDA looks into the profitability of a business or company.
NOI's formula accounts for revenue lost to vacancies — EBITDA doesn't do this.
When To Use NOI Real Estate (and When Not To)
NOI real estate is useful, but there are times you should use it and also situations where you shouldn't. Knowing the difference between the two is crucial.
A growing number of investors are using NOI to ascertain the cash flow and profitability of income-generating properties or possible deals. However, NOI real estate only considers property profitability. It won't help you out with:
- Interest payments
- Capital expenditures
How To Improve NOI Real Estate: 4 Options
NOI real estate is something you can improve upon. In addition to the aforementioned suggestions for getting above your local NOI average, consider these techniques:
Improving NOI Option #1: Minimize Your Turnover
Survey your residents on a regular basis to find out their concerns. Then, address them to minimize the expensive cost of turnover. This can help improve your NOI.
Improving NOI Option #2: Lower Your Labor Costs
Bid all your contracts out with a minimum of three contracts. Go with anyone reasonably priced but has great referrals.
Also, consider any tasks you and your team might do yourselves onsite.
Improving NOI Option #3: Opt for Ancillary Income
Vending machines, reserved parking, laundry facilities, and dog-washing stations are all extra services that residents might pay for while boosting your property's NOI.
Improving NOI Option #4: Save Water and Energy
Anything from water-saving toilets and low-flow showerheads to faucet aerators and LED or CFL lightbulbs can minimize monthly utility bills for your property — and improve your NOI.
NOI Real Estate: The Bottom Line
NOI real estate 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 real estate is an immensely beneficial tool and can help you on your real estate investing journey.