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To outsiders, it may seem that if you have capital in hand, you don’t have to worry about anything. On the contrary, anybody who is interested in investing in real estate should first educate and learn the basics of real estate. It involves both practical as well as theoretical learning. While there are things you will only learn with experience such as how to make an offer or how to transfer the title of the property, there are things that you need to get familiar with such as net operating income (NOI).
Anybody interested in investing in real estate stands to benefit from knowing what NOI is in real estate. With that in mind, keep reading to learn more about NOI, including how an NOI real estate analysis can help you analyze the potential income of your next deal.
NOI is one of many parameters used to calculate how profitable a property is. More investors have recently used NOI to determine the profitability and cash flow of an income-generating property or potential deal. NOI does not consider taxes, capital expenditures, or interest payments. Instead, NOI is only used to assess how profitable property is on its own.
Calculating NOI is relatively simple–you calculate it by deducting your operating expenses from your gross operating income, which is the total revenue generated by the property before any deductions of operating expenses or taxes.
The Formula for NOI Is:
Gross Operating Income – Operating Expenses = Net Operating Income (NOI)
Operating expenses involve only the day-to-day expenses that you pay to operate your property, which may include paying a plumber, a lawyer, gardener, electrician, or property taxes. It does not include mortgage payments or any amount paid for your income taxes. When calculating the NOI for a potential investment property, you will have to assume the figures for both gross operating income and operating expenses based on market trends and research.
In the real estate world, gross operating income is also known as effective gross income. This encompasses the gross income made from the property, but it does not include credit loss from when tenants aren’t paying their rent. It also doesn’t consider any loss of rental income from when the property is vacant.
Written as a Formula, Gross Operating Income Looks Like This:
Gross Operating Income = Gross Potential Income – Losses
Ideally, any landlord or property manager would want their property to be fully occupied every day of the year. All rent payments you receive will fall under gross potential income. However, full occupancy 365 days of each year only happens in a perfect world; in reality, properties will almost always have vacant units during some portion of the year. This may be because tenants are moving due to job relocation or job loss, or perhaps tenants are unable to pay their rent. With this in mind, you would then subtract those payments from the gross potential income amount to calculate your gross operating income.
Read Also: Gross Rent vs Net Rent
Suppose you are worried about calculating credit loss or vacancy for a property that you plan to purchase in the near future. In that case, you can use the default rate on rent or vacancy rates from nearby similar properties to complete the calculation; deduct operating expenses to get the net operating income from gross operating income. Instead of taking the total amount of money you bring in from your rental property, NOI looks at the amount of money leftover (or net) after expenses.
NOI real estate is a helpful tool because it indicates how much net profit you will make from the property rather than how much revenue your property will generate. It also includes the expenses you have to pay and doesn’t count in your profit. It provides real-world outcomes despite the presence of imperfect scenarios where properties may not be occupied at total capacity every day of the year. That’s why NOI gives you the leverage to make a more insightful decision when it comes to purchasing that property.
To fully understand NOI’s meaning, it’s helpful to know which expenses are included in the calculation and which are not. Generally, any day-to-day expenses associated with operating the property fall under the umbrella of operating expenses.
This Could Consist of the Following:
These are the expenses borne by investors who chose to outsource the management of the property. It gives the landlord the ability to earn passive income since managing property takes a lot of energy and time. Landlords can hire a property manager and compensate them for a small percentage of the rent income.
Properties tend to have functional issues over time; older ones especially require routine maintenance. This expense may include payments for services provided by a plumber, electrician, gardener, or any service provider.
If a landlord hires an attorney to draft a rental lease agreement, or if ownership of the property leads to litigation, the payments for retaining an attorney would also fall under operational expenditures.
If the landlord agreed to offer some incentives to a tenant for occupying the property, such as agreeing to pay the water bill or gas bill, these expenses are also deducted from the gross income to get the NOI.
Note: Property taxes may vary by state and municipality, but whatever amount you pay may influence the NOI of a rental property.
Any amount spent on the landlord’s or homeowner’s insurance is also included in the NOI calculation.
Most landlords get confused about whether or not mortgage payments are included in the net operating expenses. Mortgage payments are not included in the operational costs. As discussed earlier, NOI considers gross income and deducts only operating expenses, so mortgage payments are not included in the equation.
It is important to differentiate what is included in real estate NOI. It is also worth knowing what is not included. The expenses, which are specific to the investor and not the property, are not included in the property.
Here is a List of the Expenses not be Included when Calculating Net Operating Income:
NOI is a popular tool for real estate investors, but it has its flaws. Here are the pros and cons of using NOI in real estate:
NOI is primarily used when you want to determine profitability for residential or commercial rental property. NOI is used both by lenders and investors, especially when looking for potential real estate deals. Lenders can get an idea of whether or not investors will generate enough cash flow to pay their mortgage installments. That’s why lenders also use NOI for granting commercial loans.
EBIT stands for earnings before interest and taxes. It’s calculated by deducting the operating expenses and the company cost of goods sold (COGS) from the gross income. We use NOI to estimate a property’s ability to make a profit; EBIT serves a similar function.
For example, let’s assume you have purchased a property that is expected to generate $25,000,000 in rent. Let us also assume that there is $4,000,000 worth of operating expenses and approximately $100,000 in depreciation expenses.
If we deduct the operating expenses ($4,000,000) from the gross revenue property generated ($25,000,000), the NOI would be around $21,000,000, while the EBIT would be about $20,900,000 which comes when we deduct operating expenses ($4,000,000) and depreciation expenses ($100,000) from the gross revenue property generated ($25,000,000). The difference is there because EBIT also considers depreciation expenses.
NOI is not only used to evaluate both new and existing properties in your investment portfolio, but you can also optimize your rental income using NOI. If the NOI is not where you want it to be, there are steps you can take to improve it.
Ineffective operating costs can decrease your profit. If you haven’t reviewed your operating expenses, or don’t review them on a regular basis, you’ll need to make time to do so. Review your budget for anything that can change, and find ways to optimize utility costs by saving energy or water or installing smart devices that consume less power.
Minimizing operating expenses is only half of the story. The other half is to maximize your rental income. Consider revising the monthly rent you charge if it is not up to par with the market. You can also evaluate how many vacancies your properties have and explore ways to boost and maintain occupancy percentages. That may mean improving your marketing techniques and offering move-in incentives for prospective tenants.
If you have applied both the techniques and it’s still not improving the NOI, it may be a good idea to add income sources to the property, such as charging pet fees, parking charges, or offering improved amenities for extra charges.
Net operating income in real estate is the calculation of revenues generated by a property compared to the expenses incurred by the property. You can use it to draw a comparison with the property’s value as if you’d paid for it entirely in cash. So, an excellent NOI means you want a higher NOI in comparison to the purchase price of the property.
If you can make the right real estate evaluations, you can make more informed decisions as a real estate investor. Now that you know NOI’s meaning and what NOI is in real estate, you are fully equipped to analyze your potential real estate deals.