Welcome to a segment of Real Estate Investment!
The ultimate goal is to help you understand and calculate the capitalization rate. But before this can be achieved, we must understand Net Operating Income. As it is commonly called NOI, is a concept that is critical to the understanding of investment real estate. Therefore this article will be a preamble to the Cap Rate article that you can access here Capitalization Rate (Cap Rate).
You can come back as often as you want and use the FREE Net Operating Income Cost Calculator.
Your real estate professionals need to be familiar with various methods of valuation of income properties. BEWARE of those who can exhale commercial real estate words. They sound knowledgeable and seem to have a good understanding of commercial real estate, but the fact is, most DO NOT. I have heard many of them verbalize or write things in the listing like “a good cap rate; excellent profits; positive NOI” or something to those effects. However, when questioning them on the matter, it becomes evident that they have a minimal understanding of what they are saying. PLEASE BEWARE!
Investors that built their real estate portfolio in the purchase, development, rental or sale of commercial properties must consider many factors before committing their money and proceeding to make a “deal.” Investors want to evaluate and be critical of the property and see if the profitability, financing and risk make sense in the decision-making process— should they purchase the property. Therefore, the term net operating income (NOI) is pivotal to any discussion of commercial real estate.
WHAT IS NET OPERATING INCOME (NOI)
NOI is used in many calculations, formulas and ratios by real estate investors and financial services. Understanding the net operating income of an income-producing investment property helps investors make an informed purchasing decision. It is an essential component in commercial real estate.
Investors are trying to measure the profitability of their present or any investment property they are seeking to make a deal. In a derogative way, real estate investment central focus is not about the assemblage of siding or bricks, carpets or bathroom fixtures. Instead, investors don’t decide to buy properties; they choose to buy the income streams of those properties. It is all about the stream of income generated by the property while excluding certain specific factors like financing, capital expenditures, depreciation and so on, which will be explained later.
The formula of NOI expresses an objective measure and analysis of the profitability and viability of the income stream real estate investment property. It figures out how much money it brings in after factoring it’s acceptable and qualifying expenses.
NOI helps in answering vital questions. What is the potential profit? How financially healthy is the property? What are the anticipated economic benefits?
NET OPERATING INCOME (NOI) FORMULA
Net Operation Income Equals =
Gross Rental Income
+ Other Annual Income
– Vacancy Loss
– Annual Operating Expenses
Calculating net operating income is relatively straightforward once you break down each of the individual components.
Gross Rental Income:
This component is the total of the property’s annual gross income collected from the combined rent of each rental or leases assuming that the property is 100 per occupied.
For example, if each unit in a five-plex is rented at the monthly sum of $1200, this would provide a monthly gross income of $6000. The yearly gross rental income is $72 000.
Other Annual Income:
This refers to the total of any additional yearly stream of income that the property generates excluding any rental income. Here are some typical examples of other revenue income sources:
Service charges or late fees
Facility rental (event rooms, meeting rooms)
Billboard or sign income
This component refers to the yearly income lost due to either tenant vacating their rental or lease premises and/or tenant defaulting on their rental or lease agreement. For example, if a rental unit rent is $1300 per month and the unit was vacant for three months during the year, you would multiply $1300 by 3 and the yearly vacant lost for that particular unit would be $3900.
On a side note, and not to add confusion, it is essential to understand that potential rental income less vacancy and credit losses equal Effective Rental Income.
Annual Operating Expenses
Operating expenses are all the expenditures needed to maintain the property and to ensure its ability to continue to produce income. In other words, these are all the expenses required to maintain the property and run the rental business.
The term, operating expenses many times causes confusions. Many are under the impression that “If I pay for the expenses, then it is an operating expense.” THAT IS NOT ALWAYS TRUE! Some expenses are excluded in the Annual Operating Expenses component. These excluded expenses will be detailed later. But first, common commercial real estate operating expenses include
Salaries and wages (Management fees)
Property management fees
Repairs and maintenance (not capital expenditures)
Lawn and gardens care
Servicing vending machines, pools, HVAC systems
Some expenses are NOT INCLUDED or divorced from the Annual Operating Expenses component and as such does not have any effect on calculating the Net Operation Income. Here are common expenses that are excluded when calculating NOI.
Mortgage payments and interest
Loan payments and interest
Improvements and additions
Personal income tax liability
Amortization and depreciation (capital expenditures)
Leasing commission (paid to real estate broker or a representative)
Tenants improvements (construction in the tenant’s usable space to make the rental viable for a specific tenant)
Reserve or replacement fund (however, most lenders will include in their calculations to determine debt service and loan amount)
FREE NET OPERATING INCOME COST CALCULATOR
The handy FREE calculator will make life a little easier than doing the calculations on your own and will determine the property’s NOI. When using this calculator, you will be prompted to enter specific data inputs: annual gross income; other income; vacancy loss and operating expenses. Remember NOI is typically calculated yearly, so you will need to convert your monthly rents and expenses to annually by multiplying by 12.
EXAMPLES OF NOI CALCULATIONS
Lisa, a real estate representative, is evaluating two triplexes for her commercial investor clients. The following components are stated on the Seller’s annual income statement.
Triplex # 1
Rental income: $50 000
Property management fees: $10 000
Property taxes: $7500
Repairs: $10 000
Triplex # 2
Rental income: $30 000
Property management fees: $500
Property taxes: $1000
Lisa used NOI to analyze and evaluate these triplexes to find out which one of these buildings are worth purchasing or would most likely be a better investment for her investor clients. Here’s how she formulates her opinion.
The first triplex generates substantial more gross revenues during the year than the second building. It also requires more operating expenses than the second triplex. Applying the NOI formula would show that Triplex #1 net operating income is $17 500 and Triplex #2 is $27 000. After careful analysts of both buildings, NOI trend over a period of time may prove that the second triplex is the better investment.
Mike is looking at listing an office building. The gross annual income is $150 000 with a 100% occupancy. However, $14 500 was lost on vacancies. The five categories of operational expenses reported by the owner totalled $75 500. When these expenses and losses are subtracted from the gross annual income, the NOI is $60 000.
HOW TO INTERPRET NET OPERATING INCOME
In its simplistic interpretation:
The higher the NOI, the higher the property value.
The higher the NOI, the higher the cash flow.
A property with a high (positive) net operating income is a good thing. It means the properties operating revenue stream exceeds the properties operation expenses. This is what savvy commercial investors seek to consider in making a “deal.” They will analyze the NOI trend over several years, to get a frank understanding of how the properties NOI has changed over time; breaking even, trending upward or moving downwards (deteriorating).
A negative (deteriorating) NOI indicates that the operating expenses of a rental property exceed its revenues. Signalling an alarm or raising a red flag to investors suggesting that the property is not a viable investment without remedial action.
Anyone looking at investing in income-producing properties will carefully examine and analyze the properties NOI and interpret it’s trends, before pursuing a deal and formulating a bid.
Net operating income is an essential formula, among others, used to evaluate whether a rental property is worth investing. This vital calculation gives investors a good insight into the financial health of an income property. It is an essential step in evaluating the economic viability of an income property.
Keep the NOI formula in mind and also be aware of what’s included and excluded from the NOI, and you will be in a sound mindset for understanding net operating income for any property.
Don’t forget; the FREE cost calculator will help figure out the NOI for you!
OTHER HELPFUL ARTICLES / LINKS
ABOUT THE AUTHOR
The above Real Estate information topic of discussion was provided by Marc Martin, Your Real Estate Guru! Marc created marcrealestateguru.blog site because of a need to provide a trustworthy, authoritative and a leading blogging home to “Keeping Real Estate…Real.” Its various insightful blogs will benefit Sellers, Buyers, Realtors and anyone interested in Real Estate. Genuineness, truthfulness and straightforwardness are the building footings for every article. Marc can be reached by email at firstname.lastname@example.org or by phone/text at (705) 676-7799.
Marc has helped people move in and out of many homes in the Temiskaming Shores area and strives for perfection in every transaction. “I do more because you are worth more, and being a protector of my client’s interest is the single most crucial factor in my business!”
Copyright © 2018 Marc Martin
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