How to Calculate NOI, or Net Operating Income, determines, and drives what you should pay for a deal and the debt you can get. As a real estate investor, your job is to increase the NOI. First, find out how to calculate it and then how to increase it.
NET OPERATING INCOME DEFINITION
Net operating income (NOI) is a calculation used to analyze real estate investments that generate income. Net operating income equals all revenue from the property minus all reasonably necessary operating expenses.
HOW TO CALCULATE NET OPERATING INCOME
You must first figure the gross operating income. Gross operating income (GOI) is the gross potential income minus vacancy and credit loss. Gross potential income is the income you’d make if every unit in your complex was rented out every day of every year. That’s the potential of the investment. Will you make that? Not likely because you will have some vacancies and issues like tenants not paying their rent on time or the full amount, etc. That’s why you subtract the vacancies and any credit loss that you can predict.
Following trends, and the history of you’re the property will show you the vacancies you can expect as well as the past tenant’s behaviors and actions in paying on time, paying with checks that don’t bounce, etc.
Now you want to determine the operating expenses of the property. This includes management costs, legal fees, accounting fees, insurance, janitorial, maintenance, supplies, taxes, utilities and any on-going costs that reoccur to keep the property up and running.
There are also expenses that are called above the line and below the line.
Above the line: What it takes to operate the property
Below the line: Big maintenance issues that doesn’t affect the NOI
Subtract the operating expenses from the gross operating income to arrive at the next operating income.
Net operating income = Gross operating income – operating expenses
WHAT’S NOI USED FOR
Commercial lenders use different qualification criteria to determine if they will give you loan to purchase the property and exactly how much. An interesting sidenote: investor/owners usually aren’t judged on their credit history because it’s not as important to the lender as the income generating potential of the property to be mortgaged, the NOI.
This is very different from buying a single-family home. In that case, a bank evaluates the potential person on their ability to pay the mortgage and their history of paying their debt obligations. When looking at commercial property, the lender is interested in the cash flow from the income.
The lender will evaluate the property based mostly on the income it will generate. Property condition and other issues matter, but income is the biggest factor. Banks will base the loan amount on if the property can service the debt, meet the loan payments and still have an acceptable monthly cash flow.
2. Price of the Property
NOI determines the value of the property. The net operating income is used to determine the CAP Rate, which is then used to find out what the property should be valued at.
CAP RATE DEFINITION
The capitalization rate, or cap rate, is the ratio of Net Operating Income (NOI) to property asset value. It is the rate of return on a real estate investment property based on the income that the property is expected to generate.
So, for example, if a property recently sold for $1,000,000 and had an NOI of $100,000, then the cap rate would be $100,000/$1,000,000, or 10%.
As I said before, as a real estate investor your job is to increase the NOI. You can do this by:
– Increasing rents
– Decreasing expenses
– Or forced appreciation into the property
You live and die by the NOI. Learn how to calculate it, learn the importance of it and how to use it to your advantage.
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