How to Understand Net Operating Income
Understanding net operating income (NOI) is important when looking at a real estate investment. NOI is the driving number behind the valuation of commercial real estate like apartment buildings. As a passive investor, it’s important to understand where the number comes from, how NOI is used and the significance of it.
What is NOI?
NOI stands for net operating income.
To calculate the NOI, you take the property’s gross income and subtract it from its operating expenses.
NOI = GROSS INCOME – OPERATING EXPENSES
For example, if a property has a gross income of $1 million dollars, and its operating expenses are at 40% (or $400,000), then the NOI is $600,000.
NOI = $1,000,000 – $400,000 = $600,000
In order to understand NOI, we have to understand what gross income and operating expenses are – the two components used to calculate NOI.
Gross income: A property’s gross income is the TOTAL amount of income produced by the property. This could be from rents, application fees, late fees, pet fees, laundry, parking, trash pick-up, and storage. Basically, every dollar of income produced by the property is included in the gross income.
Operating expenses: Operating expenses are expenses that the property incurs over the course of normal business. A property’s operating expenses are expenses strictly related to the operations of the property. This includes real estate taxes, insurance, staff salaries, property management, utilities, and repairs and maintenance.
What’s Not Included in the NOI
It’s important to note what the operating expenses (and hence the NOI calculation) does not include.
Two important things that operating expenses do not include are debt service and capital expenditures.
The reason debt service is not included in the operating expenses is that this is discretionary. The owner gets to decide what sort of debt (if any) is going to place on the property, and this will vary from owner to owner.
Someone might buy a property for all cash, someone else might leverage it up to 80%, while someone else might be levered up to only 50%. Furthermore, another person might have a 10% interest rate, while someone else has a 4% interest rate. In essence, the debt itself has nothing to do with the business of the property, so it is not included in the NOI calculation.
The second thing not included in the NOI calculation are capital expenditures (CapEx). A capital expense is an improvement to the property. For example, renovating a kitchen improves the property and increases the value of the property, so this would not fall under an operating expense. This would be a capital expenditure.
Uses of NOI
So you might be wondering why you should care about NOI as a real estate investor?
To put it simply, the NOI determines the return on your investment. The goal is to try to get the NOI as high as possible, because the NOI determines the value of the property and also the cash flow that comes to you.
NOI can be used to calculate different things in a real estate investment:
#1. Cap Rate
The cap rate is obtained by taking the NOI and dividing it by the purchase price.
CAP RATE = NOI/PURCHASE PRICE
As you can see from the formula, the higher the NOI, the more the property is worth. NOI drives the valuation of the property.
#2. Debt Service Coverage Ratio (DSCR)
NOI is also used to calculate the debt service coverage ratio (DSCR).
To get the DSCR, the NOI is divided by the debt service:
DSCR = NOI/DEBT SERVICE
The DSCR shows how many times the income will cover the principal and interest of the mortgage payment. As an investor, you want to see a good cushion in place (typically above 1.25), because you want to see that the property has enough income to cover above and beyond the debt payments.
#3. Cash Flow
A third metric that NOI is used to calculate is cash flow.
CASH FLOW = NOI – DEBT SERVICE
Cash flow is the money the property makes after all expenses, including the debt, is paid. This is the money you get to pocket after all expenses are paid.
Summary
In summary, net operating income is an important metric to understand as a real estate investor. NOI drives the valuation of a property and the returns you get from your investment.
